Law and the Blockchain

• Author: Usha R. Rodrigues
• Position: M.E. Kilpatrick Professor of Law, University of Georgia School of Law
• Pages: 679-729

Law and the Blockchain Usha R. Rodrigues * ABSTRACT: All contracts are necessarily incomplete. The inefficiencies of bargaining over every contingency, coupled with humans’ innate bounded rationality, mean that contracts cannot anticipate and address every potential eventuality. One role of law is to fill gaps in incomplete contracts with default rules. Emerging technologies have created new, yet equally incomplete, types of contracts that exist outside of this traditional gap-filling legal role. The blockchain is a distributed ledger that allows the cryptographic recording of transactions and permits “smart” contracts that self-execute automatically if their conditions are met. Because humans code the contracts of the blockchain, gaps in these contracts will arise. Yet in the world of “smart contracting” on the blockchain, there is no place for the law to step in to supply default rules—no “legal intervention point.” The lack of a legal intervention point means that law on the blockchain works in a fundamentally different way from law in the corporeal world. Business organizational law provides a prime example of how the law uses default rules to fill gaps in an incomplete contract and how the law works differently in the blockchain context. I. INTRODUCTION ............................................................................. 680 II. ORGANIZATIONAL LAW AS A GAP FILLER ...................................... 686 A. T HE F IRM AS AN I NCOMPLETE C ONTRACT ................................ 686 B. T HEORIES OF THE C ORPORATE F ORM ....................................... 691 1. Limited Liability ............................................................ 692 2. Asset Partitioning .......................................................... 694 3. Exceptions that Prove the Rule .................................... 695 III. THE 2016 DAO ............................................................................ 697 A. B ACKGROUND ......................................................................... 697 B. G OVERNANCE OF THE 2016 DAO ............................................. 701 C. T HE “H ACK ” AND H ARD F ORK ................................................. 704 * M.E. Kilpatrick Professor of Law, University of Georgia School of Law. I thank participants of the University of Washington Faculty Workshop Series, the First Annual Works in Progress Program on Blockchains and the Law, the Minnesota Law Faculty Works in Progress Workshop, and the 2018 Law & Entrepreneurship Retreat. 680 IOWA LAW REVIEW [Vol. 104:679 D. T HE DAO’ S U NEASY F IT IN E XISTING O RGANIZATIONAL L AW ............................................................ 706 IV. THE PROMISE OF THE BLOCKCHAIN .............................................. 708 A. L IMITED L IABILITY .................................................................. 710 B. A SSET P ARTITIONING V IA C ONTRACT A LONE ............................ 713 V. LEGAL INTERVENTION POINTS ...................................................... 714 A. T HE P URE B LOCKCHAIN B USINESS O RGANIZATION .................... 715 1. The Possibility of a Purely Blockchain Entity .............. 715 2. The Problem of Blockchain Governance .................... 717 B. C ORPOREAL E NTITIES WITH A SSOCIATED B LOCKCHAIN O RGANIZATIONS ...................................................................... 721 VI. CONCLUSION ................................................................................ 727 I. INTRODUCTION In 2016, a decentralized autonomous organization (“DAO”) launched on Ethereum, a platform that permits layering programs called “smart contracts” on top of a cryptocurrency. 1 This DAO was “decentralized” because no one person or entity controlled it; it was “autonomous” because it ran itself, and it was an “organization” of a type the world had not seen before. More of a “virtual venture capital fund” than a corporation, the 2016 DAO (as I will term this particular DAO) sold tokens in cyberspace that entitled the holders to certain voting rights, including the right to vote on proposals for projects that the DAO would fund. 2 The 2016 DAO might sound like unintelligible science fiction, but businesses organized in the virtual world of the blockchain have raised millions of dollars over the past eighteen months using this platform. 3 For purposes of this introduction, all the reader needs to understand is that blockchain technology permits “smart contracts” that allow coders to layer on top of currency exchanges particular conditions under which those exchanges will occur. 4 In other words, these contracts are self-executing. The Ethereum blockchain can record not only “X paid Y nine ether,” but also “X 1. Kevin Werbach & Nicolas Cornell, Contracts Ex Machina, 67 DUKE L.J. 313, 350 (2017). 2 . Id. ; dat81, What If the Whole World Was Operated by Blockchain? , STEEMIT, https://steemit.com/ crypto/@dat81/what-if-the-whole-world-was-operated-by-blockchain (last visited Oct. 31, 2018). 3. Giulio Prisco, The DAO Raises More Than $117 Million in World’s Largest Crowdfunding to Date , BITCOIN MAG. (May 16, 2016, 2:09 PM), https://bitcoinmagazine.com/articles/the-dao-raises-more-than-million-in-world-s-largest-crowdfunding-to-date-1463422191. 4. Antonio Madeira, The DAO, The Hack, The Soft Fork and The Hard Fork , CRYPTOCOMPARE (July 26. 2016), https://www.cryptocompare.com/coins/guides/the-dao-the-hack-the-soft-fork-and-the-hard-fork. 2019] LAW AND THE BLOCKCHAIN 681 will pay nine ether Y if the Dow Jones Industrial Average reaches 30,000” (ether being the unit of cryptocurrency on the Ethereum blockchain). 5 These smart contracts enabled the 2016 DAO to implement fairly sophisticated governance and exit rules autonomously on the blockchain. The 2016 DAO was an enormous success—raising $150 million worth of ether in just a few months. 6 It was also a tremendous failure: Because of a flaw in its code, an unknown individual was able to siphon about $50 million into a private account, before being foiled by a technological fix that unwound the DAO and restored all DAO participants’ ether to its original holders. 7 Although the 2016 DAO failed, entrepreneurs following its lead launched 235 initial coin offerings (“ICO”) in 2017, raising a total of $3.7 billion from the public. 8 DAOs may represent a dead-end in the history of business organizations—that remains to be seen. 9 What matters for the purposes of this Article is what the 2016 DAO can tell us about the nature of contract law and business law, and the potential for the blockchain to upset fundamental expectations about the role of law in both fields. Academic literature teaches, quite correctly, that all contracts are incomplete. 10 For one thing, it would be inefficient for two parties to try to anticipate each and every future contingency and hash out an appropriate contractual response. 11 But even if two parties were ambitious and patient enough to attempt such a feat, it would prove impossible. Given the bounded rationality of humans and the uncertainties of life, one simply cannot contract for every future possibility. 12 5. The astute reader may wonder how the blockchain knows when the Dow Jones Industrial Average reaches 30,000. This question of how the blockchain receives reliable input from the outside world is a key problem blockchain businesses must address. Artem, How Do Oracle Services Work Under the Hood? , STACK EXCHANGE: ETHEREUM, https://ethereum.stackexchange.com/ questions/11589/how-do-oracle-services-work-under-the-hood (last visited Oct. 31, 2018). 6. Madeira, supra note 4. 7. To be precise, the Ethereum blockchain forked, creating two parallel Ethereum blockchains, Ethereum and Ethereum Classic. On the more popular (and valuable) Ethereum, the code was rewritten as if the DAO had not launched. But in the alternate reality of Ethereum Classic, the DAO continues to exist and the $50 million transfer of funds did, in fact, occur. What Is Ethereum Classic? Ethereum vs Ethereum Classic , BLOCKGEEKS, https://blockgeeks.com/guides/ what-is-ethereum-classic (last visited Oct. 31, 2018). 8. Cryptocurrency ICO Stats 2017 , COINSCHEDULE, https://www.coinschedule.com/ stats.html?year=2017 (last visited Oct. 31, 2018). Note, however, that not all ICOs are DAOs. 9. Although, more DAOs are organizing. See infra Section V.A.2. 10. Ian Ayres & Robert Gertner, Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules , 99 YALE L.J. 87, 92–93 (1989). 11. Robert E. Scott & George G. Triantis, Incomplete Contracts and the Theory of Contract Design , 56 CASE W. RES. L. REV. 187, 190 (2005) (“A contract is incomplete if it fails to provide for the efficient set of obligations in each possible state of the world.”). 12. See Scott Baker & Kimberly D. Krawiec, Incomplete Contracts in A Complete Contract World , 33 FLA. ST. U. L. REV. 725, 725 (2006) (“Contracts are never fully complete, because some 682 IOWA LAW REVIEW [Vol. 104:679 A key role of contract law is to fill the gaps humans wittingly and unwittingly leave in their consensual dealings. 13 Much of the incomplete-contracting literature deals with how the law should fill these gaps. 14 Some rules are default rules that the law supplies when the parties are silent. 15 Others are immutable rules that fix certain rights, duties, and obligations regardless of the parties’ designs. 16 In both cases, the pattern is the same. Step one: Either there is a dispute regarding the interpretation of a term or an unforeseen event occurs. Step two: A court determines what legal rule will fill the gap. In the blockchain, there is no step two. Step one occurs as it always has. After all, it is humans who code the contracts of the blockchain, and so gaps arise. But in the blockchain world, step two does not occur. Because the smart “contract” is code alone, there is no gap, in the sense of an entry point, for the law to step in to fill. Indeed, the case of the blockchain...