How can smart legal contracts help?
Smart legal contracts can help businesses:
- reduce the costs of contract management (via automation and standardisation);
- increase contractual compliance (via automation and consensus);
- increase the speed at which contractual obligations are performed (via automation);
- provide for faster negotiation and execution of agreements (via templated smart contracts);
- gain improved insight into contractual obligations and point-in-time states (via automatic data capture); and
- improve a party’s capability to simulate possible future scenarios.
Let's look at each of these in more detail.
Reduced costs and increased compliance
Contract management can cost between 10-20% of the total value of a contract. Improving efficiency through automation helps to reduce these costs. For example, rather than manually processing notification requirements under contracts, these can be handled automatically. Instead of manually calculating rates, formulae can automatically do this in compliance with the contract – and feed these into other systems.
Automation can also prevent human error (eg when transcribing a result into software) or malfeasance, removing associated costs and increasing contractual compliance. By requiring clearly defined contractual obligations and by providing the ability to clearly track performance, smart legal contracts can facilitate increased compliance with the agreed contractual terms.
Faster performance
Automatic systems can make decisions and execute accurately in a fraction of the time humans take. This can result in faster performance of contractual obligations. When multiple automated decisions are chained together, this effect compounds as automatic execution eliminates delays from waiting for human decision makers.
Faster execution
Once a template agreement is established, contract execution can be achieved more efficiently, as variables can simply be plugged into the contract. The nature of the information to be incorporated can be enforced through template input restrictions, allowing deals to be closed faster.
Appropriate workflow checks and balance can also be implemented automatically, by requiring reviews from the right people and distributing relevant information to them before a contract is digitally signed by the organisation.
Improved insights and simulation capability
Smart legal contracts can provide the data needed to measure contractual performance and spend, by directly integrating analytics. For example, a smart legal contract can automatically capture the exact time that certain goods arrive based on an RFID chip, which can be fed into a real-time inventory management system.
At a higher level, many common contractual obligations will be expressed in code or at the very least in a standardised manner. This means that smart legal contracts provide an instantaneous view of portfolio level obligations, instead of the current manual process of analysing all contracts to understand these obligations.
A history of minor non-compliances can be automatically recorded, and across a portfolio of agreements, terms can be negotiated in that trigger defaults after certain thresholds are exceeded – or the information used to determine which vendors are performing better. By building this data into all of your smart legal contracts, you can facilitate the capture of data from all vendors and build this level of analysis into your contract management process.
This wealth of data also allows you to better simulate future scenarios, by modelling the impact of different parameters against actual performance. For example, if a delivery time is consistently missed, you could model the impacts of extending timeframes, pushing for higher penalties etc – and determine how this compares with historical data.
How are smart legal contracts currently being used?
While most work in this field remains theoretical, commercially useful smart legal contracts have started to be implemented in the last 5 years. Overseas, we've seen smart legal contracts automate:
- parametric insurance for solar energy providers, where a claims obligations and a bordereau are automatically generated based on weather data ingested via an API; and
- fuel surcharges in freight transportation contracts, where applicable fuel surcharges are automatically calculated based on public fuel price data and shared to a blockchain.
We expect to see more use cases internationally as the technology matures.
What benefits does a smart legal contract have over traditional electronic data interchange (EDI) systems?
By bringing the potential for automation earlier into the negotiation process, smart legal contracts can help parties unlock more business value by establishing legal positions that are amenable to automation, as discussed above.
Smart legal contracts also have the ability to provide for richer automation in a standardised and more transparent manner. A smart legal contract can, for example, execute an agreed process in a transparent manner via a trusted third party or blockchain, thus preventing the need for results to be double checked at both ends. This can allow for untrusted business processes to be executed in a coordinated and trusted manner. In contrast, a traditional EDI system only provides a way for parties to pass data back and forth between each other and their respective internal systems.
There are also significant contract management benefits in using smart legal contracts to reduce the amount of paper/human management to answer business queries around contractual positions. Smart legal contracts prevent the current arduous process of manually assessing all contracts to provide a view of obligations across a large portfolio.
Smart legal contracts can also enable parties to more effectively manage their risk than traditional EDI systems. Find out more in Part 3.
Which clauses could we automate?
In working out which clauses are amenable to automation, there are a few key factors we'd suggest considering, set out below.
Business as usual (BAU) clauses
Clauses which reflect 'business as usual' arrangements are likely to unlock more value via automation, as they're what's used most often, so automation will likely have the greatest impact.
Eg automating the monthly payments under a lease
Trusted data sources (oracles)
Clauses which can rely on trust data sources (both external and internal) are better candidates for automation. Data sources can be, for example, published data available through a web API, or information sent by an Internet of Things (IoT) sensor
Eg automatically pulling through the Bank Bill Swap Rate into a financial instrument
Easily capturable logic
Clauses which have clear, easy to capture logic are more likely to be automatable. In contrast, 'fuzzy' concepts like reasonableness are more likely to require human intervention.
When drafting it is worth considering what business value maybe unlocked by parameterising a clause so that it can be automated (ie setting out specific criteria and tolerances)
Eg a parametric insurance contract for drought events
Business value unlocked by state-based triggers
Clauses where business value can be unlocked by triggering external actions depending the state of that clause are excellent candidates for automation
Eg automatically triggering notice provision under an SLA when a breach is detected, to start the clock sooner
Value in seeing the point-in-time state of the clause
Clauses where there is value in seeing the state of rights, obligations or other parameters at a particular point in time are good candidates for automation
Eg automatically detecting stock shortages via RFID embedded goods
Underscoring all of this is a balancing of the commercial value obtained against the cost of implementation. Developing automated clauses can take significantly more time than writing them in natural language. Reviewing and testing to ensure accurate execution adds further costs. However, if the right candidate clauses are selected, the commercial value of automation can outweigh these costs even in the short term, and over the lifetime of a contract savings will accrue.