Blockchain Smart Contracts | Fraud, Taxes & Evidence

The Case for Supporting Automated Contracts with Traditional Legal and Audit Documentation

Blockchain enthusiasts envision smart contracts, where assets and transactions are governed on the type of shared ledger that controls Bitcoin.

Here is an example of a “smart contract:” Alice, Inc. earns bitcoin by mining. Alice controls a bitcoin account to which earned bitcoin is added from time to time. Alice, Inc. promises to pay Bob Corp. 25% of the bitcoin added to the account each week. (Assume the value to be paid Bob is around $250,000 per year.) Alice management sets up this transaction by adopting rules on a functioning, publicly-accessible Ethereum-based blockchain. The functions of the blockchain automatically execute the transaction and cause the requisite bitcoin to move from Alice’s account to Bob’s bitcoin account.

The transaction is functionally complete, but poorly documented.

In principle, this transaction is functionally complete. In principle the code on the blockchain could control and execute the transaction as intended by Alice and Bob.
Crypto 2.0 Needs Scrivener

However, I argue that for many businesses like Alice, Inc. the transaction needs more legal and audit documentation. The establishment of rules on a public blockchain ledger may not be enough to satisfy Alice, Inc.’s responsibilities to stakeholders, including shareholders, creditors and tax authorities.

Now, management at Alice, Inc. might (hypothetically) disagree with me. Management might argue that by setting up the transaction on the blockchain it has undertaken and documented a transaction that is just as legally-binding as a promise made with paper and ink. The blockchain is open for public inspection. Anyone can inspect the function of the blockchain and the open-source code that runs it.  Anyone can monitor the transactions recorded and executed on the blockchain. The transactions are executed under publicly-known, publicly-validated cryptographic security measures, including hash algorithms and digital signatures.

Accordingly, argues management, even if the smart contract does not execute, Bob Corp. can still refer to the code recorded in the blockchain as evidence of the intent of the contract and thereby enforce the contract in a court of law just as if it were written in ink on paper.

Judicial cases support the proposition that a smart contract could be enforced in court.

In support of its position Alice management might cite case law interpreting security measures instituted with respect to property such as land. Courts have long evaluated the “security measures” instituted on land to ascertain whether rights of ownership to land have changed by way of “adverse possession.” Those security measures have included gates, locks, fences and the like.

So, for example, a New Mexico court said that adverse possession of land could be interpreted from the history of locks used on a gate that controlled access to the land. Dethlefsen v. Weddle, Opinion Number: 2012-NMCA-077, New Mexico Court of Appeals, 2012.

Similarly Mississippi courts have said that adverse possession of a parcel of land could be interpreted by examining fences on the land, including their location, history and purpose.

To understand evidence of security measures, a court may need to hear testimony from witnesses, such as people who understand the land in question.

In other words courts have much experience examining publicly gatherable evidence of security measures used to control property and then interpreting that evidence as a record of the rights and ownership pertaining to the property. Another way to say it is that the function of fences, gates and locks is a form of language, and with enough effort a court can come to understand that language.

Courts can interpret security measures, just as they can interpret words written on paper.

If courts can do that for land, argues Alice Inc.’s management, then courts can do it for logical evidence that can be seen by all on a blockchain. Just as courts can hear testimony from witnesses who know land, courts can hear testimony from cryptographic experts who understand blockchains.

In theory, if the blockchain stopped functioning, and Alice otherwise refused to transfer the bitcoin to Bob Corp., Bob could sue for breach of contract and win a judgment against Alice. With the help of qualified witnesses, Bob could prove the existence and meaning of the smart contract by referring to the code and security measures used in the blockchain.

A contract need not be written in natural language in order for a court to understand it or enforce it. So argues management at Alice, Inc., who believes no additional documentation is necessary.

Good business documentation seeks more than just enforceability in court.

But I have a rebuttal to the foregoing hypothetical argument by management at Alice, Inc. Just because a contract is legally enforceable does not mean it is documented well enough for accounting purposes.

Alice’s management may be correct that the smart contract is written, recorded, understandable and enforceable.

Nonetheless, Alice, Inc. still has problems with this transaction. Good business practices expect businesses to better document substantial transactions like a promise to transfer roughly $250,000 in value per year.

A promissory note is greater documentation than is a mere notation in a ledger.

A business like Alice, Inc. needs to account to stakeholders. One example of a stakeholder might be a bank that has lent money to Alice and expects Alice to repay the loan and otherwise maintain a strong balance sheet. Another example of a stakeholder would be a corporate shareholder. If Alice is a larger corporation, it could well have numerous shareholders, including founders (and their heirs and family members) angel investors, venture capitalists and employees.

Promissory Note to Support Autonomous Contract

Critical to a business’ accounting to stakeholders is its maintenance of books, ledgers and documentation to show revenue, expenses, assets, liabilities and so on. Those books, ledgers and documentation enable a third-party auditor to review and opine on the financial statements the business provides to stakeholders.

But if Alice’s evidence for its obligation to Bob is just the entries on a public blockchain, that evidence may not satisfy the auditor. The auditor may lack the expertise to interpret the blockchain. Blockchain technology is very new and very complex. Few accountants in the world are today qualified to review a blockchain.

Alice’s auditor may refuse to approve Alice’s financial statements . . . or may flag the poorly-documented contract as a problem.

Famous court case calls for backup documentation.

An instructive court case is SEC v. World-Wide Coin Investments, 567 F.Supp. 724 (N.D. Ga. 1983). World-Wide Coin was a small, publicly-owned company. It was subject to the US securities laws, including the requirement that it “make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets of the” company. 15 USC § 78m(b)(2)(A). The court found that the company had failed to satisfy that requirement for records. Among many other recordkeeping defects, the court found: “no promissory notes or other supporting documentation has been prepared to evidence purported loans to World-Wide.”

In other words, at this company obligations to pay money (repay loans) were supported by only sketchy notations and/or memories stored in the heads of staff members. But the court said that’s not good enough to serve the interests of stakeholders (even though the people to whom money was owed were not complaining). Sketchy notations and human memories are inadequate to constitute “reasonable records.” Obligations to pay money need to be documented by written evidence like promissory notes or contracts.

Outside auditors demand good documentation.

Let’s apply the World-Wide Coin lesson back to Alice, Inc. Its outside auditor will expect Alice to have reasonable records of obligations. (Further, under general corporate law Alice’s creditors and shareholders also expect Alice to maintain reasonable records of obligations.) Those records give the auditor comfort that the financial ledgers shown to the auditor are in fact accurate.

If the auditor is uncomfortable with the quality of Alice’s documentation, the auditor could point to the World-Wide Coin case for the proposition that Alice is deficient (even if Alice is not a publicly-owned company that must comply with the securities laws like 15 USC § 78m(b)(2)(A)).

In the mind of the outside auditor, deficient documentation of transactions could be a symptom of deeper problems at Alice. 
  • One problem could simply be sloppiness such that Alice – innocently, naively -- does not understand its obligations and therefore is incompetent to account for its financial status.
  • A second, more sinister, problem could be that management at Alice is intentionally obscuring the company’s financial condition for the purpose of fraud. The poster child for this problem is Bernard “Bernie” Madoff, one of the most infamous of all financial crooks. He and the staff at his company deliberately maintained sketchy or nonexistent documentation of contracts and other transactions in order to hide the company’s true condition from auditors, investors and regulators. 

Tax authorities demand good documentation.

In regards to Alice, Inc.’s accounting documentation, another stakeholder is a tax authority. If Alice is a US company it must pay federal income tax. Alice will likely try to reduce its tax liability by claiming the transfers of bitcoin to Bob Corp. reduced Alice’s income.

In support of Alice’s claim, the Internal Revenue Service expects Alice to keep adequate records and documentation. The records and documentation enable IRS auditors to confirm Alice’s annual income.

Section 6001 of the Internal Revenue Code requires each taxpayer to keep records necessary to show whether the taxpayer owes tax.

The taxpayer has the burden to prove the authenticity of its records. Gillespie v. Commissioner, 35 T.C.M. (CCH) 269 (1976).

Sometimes, owing to inadequate documentation of transactions, IRS disagrees with a business taxpayer’s calculation of tax. In Bard v. Commissioner, for example, the IRS disallowed deductions the taxpayer had taken for the costs of precious metals purchased in cash transactions. The taxpayer had documented the purchases with little more than a fragmentary telephone log kept in a looseleaf notebook, without numbered pages. Although the taxpayer appealed to the tax court, the court sided with the IRS. It sustained the disallowance of deductions, which increased the taxpayer’s tax liability considerably. 60 T.C.M (CCH) 485 (1990).

In theory a tax auditor can understand the smart contract on the blockchain. But in practice the tax auditor may consider the blockchain to be too obscure and therefore inadequate to support Alice’s tax claims.

Accordingly, Alice, Inc. may be saving itself heartache in a tax audit by supporting the smart contract, at the outset, with a traditional, written promissory note.

Why is a promissory note needed?

In all likelihood the code for a functioning smart contract will not include all the information that is critical from a legal or accounting perspective, such as the precise legal name of the parties (Alice, Inc. and Bob Corp.).

The process or drafting a promissory note or similar document – to stand along side a smart contract -- imposes intellectual and ethical rigor on business people and programmers who may otherwise be in a hurry. In my experience executives and coders can dash-off ideas and deals quickly, with little regard for the details that may not seem important at the time.

But those details are the domain of the scrivener (the document draftsman). The disciplined scrivener knows that a promise to pay needs to nail down topics such as the precise legal identity of the parties, whether the promise was made by an authorized officer of the promising company, whether the obligation to pay can be enforced in court (outside of the blockchain), and more.

Conclusion: Smart contracts and traditional documentation complement each other.

Smart contracts are good, and companies like Alice, Inc. should use them where they make sense. But substantial smart contracts need to be supported by traditional written documentation like paper contracts or promissory notes.
What do you think? If any of my ideas are off-target, please let me know.