Exploring the ethical implications of digital assets, blockchain technology, and smart contracts in legal practice

The emergence of digital assets based on advanced technologies such as blockchains and smart contracts presents new ethical implications for the legal industry. The transformative nature of digital assets as driving technological advancement challenges established norms and raises significant questions for lawyers working with these technologies.

Lawyers are encouraged to educate themselves on the innovations related to digital assets and understand how these technologies may affect their professional practice. This alert discusses the emerging market of digital assets, and how the technologies utilized to create and manage these assets, affect lawyers’ ethical obligations and the evolving regulatory frameworks applicable to these assets.

Blockchain, smart contracts, and the current legal framework

The emergence of blockchain technology and smart contracts presents a unique challenge to the existing legal framework. Digital assets, especially those relying upon blockchain technology and smart contracts, operate in ways that are fundamentally different from traditional legal constructs, revealing certain gaps and inconsistencies in the legal system’s approach towards their regulation and control.

It is first important to consider the decentralized nature of blockchain. Traditional legal frameworks are accustomed to dealing with centralized points of control or responsibility. However, blockchain technology redistributes control across an entire network of participants. This can pose legal and regulatory challenges in situations where it is necessary to identify a single party responsible for a transaction or execution of a contract, something that is often intrinsically difficult within a blockchain network.

Second, although the immutable nature of blockchain records ensures that the security, transparency, and efficiency of transactions are always maintained, the anonymity and near-permanence of transactions recorded on the blockchain pose other legal challenges.[1]  For instance, if a transaction on a blockchain is determined to be illegal, the transaction often cannot be reversed due to the immutable nature of the blockchain.[2]  Additionally, the anonymity inherent within certain types of blockchains can clash with the demands of laws such as know-your-customer (KYC) and anti-money laundering (AML) laws.[3]  On the other hand, the integration of a blockchain-enabled AML/KYC platform can also make it easier to trace, verify, and record information related to KYC and AML.[4]

The operation of smart contracts presents further challenges. Smart contracts are terms directly written into lines of code, removing the need for third-party intermediaries. While this represents a shift towards efficiency, it also raises questions about how to handle traditional contract issues, such as the application of contract law principles, enforcement of terms, and the role of the court system in resolving disputes.

One key consideration is that smarts contracts are self-executing, meaning that, once a smart contract is coded, its execution is automatic and cannot be reversed.[5]  Should parties that deploy a smart contract have a dispute prior to execution of the contract term, the parties will be unable to prevent execution of the contract even if a party obtains injunctive relief. Therefore, a party with a dispute is required to pursue litigation after execution of the smart contract and seek relief in the form of monetary damages or another entry on the blockchain to reverse the effect of the smart contract’s execution.[6]

In addition, although smart contracts are self-executing, the contract itself and its outcomes are not necessarily legally enforceable under traditional contract principles.[7]  To be legally enforceable, a smart contract and the method of “agreement” to a smart contract must have all the attributes that make traditional contracts enforceable.[8]  While contract law in the US is governed by each individual state’s laws, the essential elements of a contract require (1) a meeting of the minds, (2) offer and acceptance, and (3) an exchange of consideration.[9]

Depending on the coding of a smart contract and ancillary documents, a smart contract may be capable of satisfying the elements of a traditional contract. For example, a transfer of funds through a smart contract might serve as the offer or acceptance, and as part of the consideration.[10]

However, it is essential that parties to a smart contract make sure the terms of the contract, and the method of “agreement” to the smart contract, are sufficiently definite and communicated to all contracting parties during the development and deployment of the smart contract.[11]  Without a governing traditional contract giving effect to the parties’ intentions, there may not be any legal recourse should a smart contract’s execution produce an erroneous result.[12]

It is clear that digital assets, including those utilizing blockchain and smart contracts, by virtue of their novel characteristics, challenge many of the conventional principles and norms within the traditional legal framework. As we strive to harness the benefits of these technologies, we must also grapple with the question of how to adapt our current legal system to address them effectively.

Ethical considerations from the intersection of digital asset technologies and legal ethics

The advent of blockchain technologies and smart contracts, and their use in connection with digital assets, has introduced an array of new legal and ethical challenges. These innovative technologies blur traditional jurisdictional lines and call into question established legal norms – and their rapid evolution presents a moving target for legal ethics.

This section delves into some of the notable ethical considerations these new technologies pose to legal professionals.

• Client confidentiality

With the advent of blockchain-based digital assets, the obligation to preserve client confidentiality, as outlined in the American Bar Association’s (ABA) Model Rule of Professional Conduct 1.6, has become complex.

The Rule clearly states that “[a] lawyer shall not reveal information relating to the representation of a client unless the client gives informed consent.”[13]  In customary law practice, this encompasses guarding client’s sensitive documents or refraining from casual discussion about active matters. However, blockchain technology has presented new challenges to a lawyer’s duty of confidentiality by providing a traceable, broadly accessible, and individually identifiable record of transactions in digital assets.

In contrast, blockchain and smart contract technologies could aid lawyers in maintaining the confidentiality of sensitive client information. As discussed above, a smart contract is a “self-executing computer program contained within a decentralized blockchain network.”[14]   Firms could use a private blockchain-based data-management system integrated with smart contracts to securely record data and keep records in a secure manner.[15]  The use of blockchain technology and smart contracts in this manner may help lawyers abide by Model Rule 1.6.

• Duty of care

The ABA’s duty of care entails acting in the client’s best interest and using judgment unaffected by personal feelings or outside influences. As technologies like blockchain and smart contracts become prevalent, there will likely be a new surge in clients seeking advice on these topics. Under the ABA’s Model Rules, Rule 1.1 emphasizes a lawyer’s obligation to provide competent representation to a client.[16]  This includes a commitment to not only possess the legal knowledge, skills, and preparation necessary for representation, but also a responsibility to stay abreast of changes in law and its practice, including the benefits and risks associated with relevant technology.

• Duty of competence

The duty of competence includes both a “substantive knowledge of law and competent use of technology that lawyers use to practice law.”[17]  In the context of blockchain and smart contract technologies, this duty of competence demands that legal professionals gain foundational understanding of how these technologies function. Lawyers who do not provide competent representation in relation to emerging technologies may be putting their clients and themselves at a disadvantage.[18]

To satisfy the duty of competence, lawyers are encouraged to actively seek continued learning opportunities to understand the complexities of blockchain and smart contract technologies. This might involve participating in legal seminars, tech workshops, or even seeking advice from experts in the field to ensure they possess sufficient understanding of the subject matter before offering advice to clients or engaging with relevant cases.

• Duty of diligence

The ABA Model Rules provide that “[a] lawyer shall act with reasonable diligence and promptness in representing a client.”[19]  The duty of diligence requires that “[a] lawyer should pursue a matter on behalf of a client despite opposition, obstruction or personal inconvenience to the lawyer, and take whatever lawful and ethical measures are required to vindicate a client’s cause or endeavor.”[20]  Blockchain and smart contracts introduce to the legal profession the prospect of automating legal decisions. In reviewing agreements in which clients may engage relating to smart contracts, lawyers should act with heightened sensitivity to the fact that automated agreements may be made with no room for review.

The regulatory response to digital assets

Prudent lawyers will also be aware of the evolving regulatory landscape of blockchain and smart contract technologies, especially when used in connection with digital assets.

Currently, regulators around the world are grappling with the challenges posed by digital assets and are aiming to understand the blockchain and smart contract technologies that digital assets often utilize and rely upon. Given the unique nature of blockchain-based digital assets, newly created legal frameworks may be needed. A new regulatory landscape for digital assets would need to balance the potential benefits of blockchain-based digital assets, like efficiency and transparency, against potential risks such as misuse, legal uncertainties, and ethical dilemmas.

In the US, digital assets continue to cause controversy in the regulatory space. While there has been “significant engagement” from US administrative agencies, little formal rulemaking has occurred.[21]  Beginning in 2022, Congress began introducing several bills aimed at providing more clarity to the emerging sector.[22]

First, the Responsible Financial Innovation Act (RFIA) was designed to “provide regulatory clarity for agencies charged with supervising digital asset markets, provide a strong, tailored regulatory framework for stablecoins, integrate digital assets into existing tax and banking law, and spur innovation in the field of digital assets.”[23]

Later in 2022, Congress introduced the Digital Commodities Consumer Protection Act (DCCPA). The DCCPA authorized the “CFTC to regulate ‘digital commodity platforms’ and ‘digital commodity’ trading.”[24]  With limited exceptions, the DCCPA gives the CFTC exclusive jurisdiction over “digital commodity” trades.

Other bills have also been introduced to help regulate the digital assets market and blockchain technology; however, the future regulatory landscape of digital assets remain somewhat unclear based on congressional intention and discussions.

State governments have further proposed regulation or passed laws affecting digital assets, smart contracts, and blockchain technology. Notably, some states have tried to “promote the technology by passing very favorable regulations exempting cryptocurrencies from state securities laws.”[25]

Conversely, other states have attempted to resist the growing market of blockchain-based digital assets. These states are “making it harder for blockchain companies to operate within their borders by requiring money transmitter licenses and/or the need to strictly adhere to state blue sky securities laws.”[26]  For example, on June 6, 2023, nine states, with the help of the SEC, filed enforcement actions against Coinbase, a cryptocurrency exchange.[27]  These enforcement actions alleged that Coinbase’s “staking rewards program” violated securities laws.[28]

States will likely continue to take different legal approaches to the regulation of digital assets, perhaps making it increasingly difficult to grasp the overall regulation of the industry.

Regulatory oversight of digital assets

The SEC and CFTC have frequently differed in their view of digital asset regulation. CFTC Commissioner Caroline Pham stated that she “comes to a different view than the SEC on whether utility and governance tokens are securities.”[29]

The CFTC has signaled that digital assets are a priority for regulatory enforcement. The agency first addressed the status of digital assets in a CEA settlement of an enforcement action (In the Matter of Coinflip). In Coinflip, the CFTC concluded that the definition of a commodity is broad and encompasses virtual currencies.[30]

The SEC, by contrast, maintains that initial coin offerings, “based on specific facts, may be securities offerings, and fall under the SEC’s jurisdiction of enforcing federal securities laws.”[31]

Although Courts have seemed to affirm the CFTC’s authority to regulate digital assets, the tension between the CFTC and SEC remains.

To help clarify regulation over digital assets, Congress has proposed the Digital Trading Clarity Act, which aims to provide clarity around two major concerns: (i) the classification of digital assets and (ii) related liabilities under existing securities laws.[32]

Ultimately, Congress will likely continue to propose new legislation to help alleviate the confusion surrounding the regulation of digital assets. For now, the regulatory landscape regarding digital assets, and the blockchain and smart contract technology enabling digital assets, remains somewhat unsettled.

Going forward

Advancements in digital assets and blockchain and smart contract technology will continue to challenge the legal practice. Amid this emergence of new technologies, evolving ethical considerations will likely remain a dominant feature of this rapidly changing landscape. These new technologies, as well as ethical guidance on digital assets, will continue to evolve, and lawyers are encouraged to remain attentive.

For more information, please contact the authors.

 

^{[1] See What is an immutable ledger in blockchain and what are its benefits?, THE CFTE BLOG (April 4, 2023). https://blog.cfte.education/immutable-ledger-in-blockchain/#:~:text=Immutability%20is%20a%20key%20feature%20of%20blockchain%20technology,transparency%2C%20and%20efficiency%20of%20transactions%20is%20always%20maintained.
[2] Id.
[3] See Akash Takyar, How Can Blockchain Simplify KYC and AML Processes, https://www.leewayhertz.com/blockchain-in-aml/#:~:text=Building%20a%20blockchain-enabled%20AML%2FKYC%20platform%20can%20streamline%20AML%2FKYC,always%20transparent%20to%20all%20members%20of%20the%20network.
[4] Id.
[5] Jeffrey D. Neuburger, Wai L. Choy, and Kevin P. Milewski, Proskauer Rose LLP with Practical Law Commercial Transactions, Smart Contracts: Best Practices, https://us.practicallaw.thomsonreuters.com/w-022-2968.
[6] See also Smart Contract Alliance, Smart Contracts: Is the Law Ready? (September 2018), https://digitalchamber.org/smart-contracts-whitepaper/.
[7] Id.
[8] Id.
[9] Id.
[10] Id.
[11] Id.
[12] Id.
[13] Model Rules of Prof’l Conduct r. 1.6 (Am. Bar Ass'n, 2020).
[14] Nick Oberheiden, How Blockchain Technology Impacts the Legal Profession, JD Supra (FEB. 21, 2023), https://www.jdsupra.com/legalnews/how-blockchain-impacts-the-legal-6422930/.
[15] Id.
[16] Model Rules of Prof’l Conduct r. 1.1 (Am. Bar Ass'n, 2020).
[17] Don Macaulay, What Is A Lawyer’s Duty of Technology Competence?, National Jurist (Feb. 2, 2018), https://nationaljurist.com/smartlawyer/what-lawyers-duty-technology-competence/#:~:text=Lawyers%20are%20precluded%20from%20pleading,they%20and%20their%20clients%20use.
[18] Kristin L. Yokomoto, October 2019 Ethically Speaking – Ethical Duty of Technology Competence, Orange County Bar Association, https://www.ocbar.org/All-News/News-View/ArticleId/3689/October-2019-Ethically-Speaking-Ethical-Duty-of-Technology-Competence.
[19] Model Rules of Prof’l Conduct r. 1.3 (Am. Bar Ass’n, 2020).
[20] Id.
[21] Josias N. Dewey and Samir Patel, Blockchain & Cryptocurrency Laws and Regulations 2024, Global Legal Insights, https://www.globallegalinsights.com/practice-areas/blockchain-laws-and-regulations/usa.
[22] Id.
[23] Id.
[24] Id.
[25] Id.
[26] Id.
[27] Id.
[28] Id.
[29] Id.
[30] See In re Coinflip, Inc., CFTC Docket No. 15-29, Sep. 17, 2015.
[31] https://www.sec.gov/securities-topics/ICO
[32] Global Legal Insights, supra note 30.}