This a continuation of 4 weeks ago’s liability overview, with a focus on challenges in actually determining liability in civil law systems.
Example of Smart Contract Liability in the Civil Law
The unlikely place that we go to today is Liechtenstein. This European micro-state operates with a Civil Code, like most of the EU (while itself not being part of the Union), with the caveat that it also has one of the world’s most comprehensive ‘Blockchain’ Acts. It makes a great case study for how the combination of a civil law code and a blockchain act can work together to address smart contract liability uncertainties.
The Principality of Liechtenstein, sandwiched between Austria and Switzerland…
Liability in Liechtenstein
As an offshoot of the Austrian civil system since 1812, liability is determined by 4 legal steps:
1. Damages – First step is determining pecuniary or non-pecuniary loss as per the relevant civil code sections;
2. Causality – Behaviour has to rise to the level of condition sine qua non (if not for). This also includes inactions where damages stem from failing to take a particular action. If not for the test is limited to foreseeability, similar to torts negligence in the common law;
3. Unlawful Action – One must show that a party has engaged in an action normally prohibited by either law or by legal requirements, such as contractual requirements. This can be akin to tort or contractual actions. This condition is not necessary to impute liability in strict liability offences;
4. Fault – The onus on the damaged party is to show that a fault as against the damaging party is in fact present. This is the hardest metric to meet as the burden of proof can be difficult. The onus is reversed if a contractual breach is alleged, and a viable contract was shown to be entered into, such that the alleged breaching party must show through evidence some external reason that prevented them from meeting the legal requirements they contracted to. Again, the condition of fault does not apply to strict liability;
Product and Corporate Liability and Blockchain
EU directives on defective products apply here. Liability is imputed to producers whose products result in damage or destruction of an item of property (electronic property is considered movable under these guidelines), where the producer is defined as the manufacturer of a finished product, the producer of any raw material, or the manufacturer of a component part that is identifiable. Corporate liability recognizes corporations as separate legal entities but also allows for what in the common law would be considered the piercing of the corporate veil in cases where liability is to be found against directors, officers, etc.
Given these legal realities, the author argues that the Civil Code can be used to solve liability challenges in the blockchain ecosystem, which they outline as follows:
In contrast to our previous examination, the author believes there is some liability to be imputed at the foundational level of the blockchain itself given the Civil Code precedents establishing producer liability. They point to cases like Google Spain v. AEPD in the EU Court of Justice as evidence that a search engine (foundational tech) could be held liable as a separate entity from the original publisher or actor of the data published/acted on. Public blockchains however are run in P2P models that make this concept of liability not really applicable in the same ‘product/producer’ dynamic that existing technology products employ. This analysis would not prevent devs from developing software products on top of these public blockchains to be protected, however, since there is a clearer distinction as to who exactly the ‘provider’ for a particular service would be.
Overall the author is in agreement that a finding of liability against the entirety of a blockchain decentralized ‘system’ would be folly, although the ‘Core’ devs for ETH, BTC, and other large public blockchains could still be found liable for specific changes to the blockchain that they propagate, but this would still be difficult when meeting the ‘fault’ requirement, given the open nature of these products, and the fact that any label of product or service still requires a liable party to pin that product or service on.
New Token Standards from the Blockchain Act
Compared to other token jurisdictions, the Blockchain Act from Liechtenstein offers unique regulations for tokens. The “Token Container Model” defines the token as a container where all types of rights may be placed within. The new model opens the token for more than just securities, including patents, music rights, trademark rights, software rights, etc.
In order to understand the smart contract concept applied by the Liechtenstein authorities, we should look into the Blockchain Act provisions that mainly govern virtual assets affairs. In fact, there is no clear guidance on or definition of the term “smart contract”, only a brief description could be found in the consultation report on the Blockchain Act – “automated contracts that can also trigger transactions with tokens”.
The Liechtenstein Blockchain Act is actually called “Tokens and TT Service Providers Law” (TVTG), and it introduces the generic word “trustworthy technology” (TT), i.e. “Technologies through which the integrity of Tokens, the clear assignment of Tokens to TT Identifiers and the disposal over Tokens is ensured”. In general, the TT as defined by law could include public and private blockchains and DLT systems.
TT Service Provider’s role is governed by the Act entailing one or more of the following functions:
- Token Issuer – a person who publicly offers the Tokens in their own name or in the name of a client;
- Token Generator– a person who generates one or more Tokens;
- TT Key Depositary: a person who safeguards TT Keys for clients;
- TT Token Depositary: a person who safeguards Token in the name and on account of others;
- TT Protector: a person who holds Tokens on TT Systems in their own name on account for a third party;
- Physical Validator: a person who ensures the enforcement of rights in accordance with the agreement, in terms of property law, represented in Tokens on TT systems;
- TT Exchange Service Provider: a person, who exchanges legal tender against Tokens and vice versa and Tokens for Tokens;
- TT Verifying Authority: a person who verifies the legal capacity and the requirements for disposal over a Token;
- TT Price Service Provider: a person who provides TT System users with aggregated price information on the basis of purchase and sale offers or completed transactions;
- TT Identity Service Provider: a person who identifies the person in possession of the right of disposal related to a Token and records it in a directory.
- TT Agent: a person who distributes or provides TT Services in Liechtenstein on a professional basis in the name of and for the account of a foreign TT Service Provider;
With the prospect of tokenization of any right or asset the Blockchain Act now acknowledges that such paper-based rights and assets can be entirely brought to the digital world and will become easily tradeable in the form of tokens.
The Token Container Model
The Token is a piece of information on a TT System which 1. can represent claims or rights of memberships against a person, rights to property or other absolute or relative rights; and
2. is assigned to one or more TT Identifiers (an identifier that allows the clear assignment of Tokens)
A right is virtually stored in a container (see the figure below) representing the token and running on a blockchain. For example, the right could be a diamond’s ownership right. Whoever owns the token owns the diamond — exactly this relation is established by the Token Container Model. The diamond does not need to move its physical location; it can remain in a vault. But the ownership of the diamond can change by transferring the token to other persons. This would make sense for a private person storing value by owning a diamond but also for institutional investors who build entire portfolios of fractionally owned diamonds (think of 1,000 investments in fractions of a diamond for the purpose of risk diversification).
Token Container Model representing a right on a diamond in a container such that it can be transferred easily without moving the physical asset in custody (Source: NÄGELE Attorneys at Law LLC, 2019)
Civil law rules are still in force regarding the qualification of tokens and their disposal on the blockchain. The object and scope of the Liechtenstein civil basis are applicable as long as the tokens are generated or issued by a TT Service Provider with headquarters or place of residence in Liechtenstein, or the Parties to a particular transaction declare the Liechtenstein Law to apply in a legal transaction over Tokens expressly.
The token key holder has the power of disposal over the Token, including the transfer of the right of disposal to the Token; or the justification of a securities or a right of usufruct to a Token. In the event that the Token is disposed of without reason or a subsequent reason fails to exist, the revocation shall be accomplished in accordance with the provisions of the Enrichment Law (§§ 1431 et seq. ABGB).
With the transfer of Token the usual civil law consequences occur. If the legal effect does not come into force by law, the transferor must ensure, through suitable measures, that the disposal over a Token directly or indirectly results in the disposal over the represented right, and competing disposal over the represented right is excluded.
The disposal of a Token is also legally binding in the event of enforcement proceedings against the transferor and effective vis-à-vis third parties, if:
- the transfer was activated in the DLT system prior to the commencement; or
- the activation of the DLT was made after the initiation of the legal proceedings and was executed on the day of the proceeding’s openings, provided that the recipient may prove actions in good faith.
The Act allows the cancellation of Tokens upon loss of TT Key or non-functional tokens. For this purpose, the person with the right of disposal should seek court authorization to waive his/her rights. In a non-contentious proceeding, the token owner shall apply for cancellation of his/her tokenized rights, as the respondent shall be the person obliged from the right represented in the token.
TT relevance to legacy agreements
Thomas Nägele one of the authors of the Blockchain Act sees Smart Contracts as interoperability with traditional contracts to enforce or verify a traditional contract by automation of the processes. “Smart contracts can, for example, automate a payment that depends on a certain condition being met or impose a penalty if a certain condition is not met. They can thus operate in typical ‘if-then’ scenarios and replace this aspect of a contract where simple and objective terms or thresholds must be met. The boundaries of smart contracts are mandatory protective and constitutional rights.”
Proper execution of the smart contracts utilizing the token container model and compliance with their provisions is automated in theory. However, the Liechtenstein regulation entrusts the essential attesting function to a physical validator who is responsible for identifying the holder of the tokens. The validator knows who are the token owners (smart contract parties) and has the duty to ensure the contractual enforcement of the represented rights and obligations, e.g. by storing the real-world assets (or rights) in a vault. With this approach, the Blockchain Act assigns the responsibility to guarantee perfect synchrony of the physical and digital worlds to the physical validator.
To extend further the example with the tokenized diamond ownership rights an effective transfer of a tokenized property is considered the conveyance of underlying right successfully confirmed by the physical validator.
In-depth review of transferring Tokenized Shares of Amazing Blocks under the Blockchain Act – https://amazingblocks.medium.com/transaction-of-tokenized-shares-on-ethereum-leveraging-the-liechtenstein-token-act-with-the-7ef65ef9b1e0
Transaction from one shareholder of Amazing Blocks AG to another shareholder can be seen here – https://etherscan.io/tx/0x4e112d750b0c2bcb799dfcc1bc836512f85ebfd13dbf26783ad8fadcccd54819
Sources: Medium publications of Thomas Nagele and Philipp Sandner