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Sector Insights

Smart Contracts: the smart way forward in logistics?


Nicola Tune

Nicola Tune Registered Foreign Lawyer (England & Wales)

This article aims to provide an overview of what smart contracts are, their possible uses in the logistics industry and the legal implications of adopting them.

What are smart contracts?

A “smart contract”, just one of the many technologies which are spurring on the Industry 4.0 movement, lacks a set definition. The original definition given by Nick Szabo in 1996 was “a set of promises, specified in digital form, including protocols within which the parties perform on the other promises” which was based on an individual’s interactions with a vending machine. This definition has been modified over the years to reflect the current understanding of the capabilities of smart contracts. The Smart Contracts Alliance (a Chamber of Commerce initiative) recently defined smart contracts as: “Computer code, upon the occurrence of a specified condition or conditions, is capable of running automatically according to prespecified functions. The code can be stored and processed on a distributed ledger and would write any resulting change into the distributed ledger.

As can be inferred from the above, smart contracts are essentially computer code which have the ability to auto execute specific functions and work by using a simple “if x then y” operating logic. For example, smart contract code can be written so that when it receives data confirming the consignment of cargo has been received by the buyer, this data is verified and the smart contract automatically releases payment which had been held in escrow to the seller.

The smart contract code can be stored and processed on a distributed ledger (for example on a blockchain) which means that identical copies of the code are kept on multiple computers in multiple locations. When one of the copies is updated, the information is verified before it is filtered through to the rest of the copies and if so coded, the smart contract carries out its function, such as registering a new owner of property.

Possible uses in the logistics industry?

Smart contracts and blockchain are being trialled in many different industries, from banking to property transactions. The nature of how smart contracts operate and their compatibility with the Internet of Things (see our previous article on Smart Mobility in the February 2019 issue), lend themselves to being highly functional in the logistics industry. For example smart contracts could be used for:

  • Letters of credit. Routinely used in the trade industry, smart contracts can provide an efficient solution for all parties involved. The transparency of blockchain allows all stakeholders (exporters, importers and financial institutions) access to view, track and digitally transfer Letters of Credit as required;
  • ­Electronic bills of lading;
  • ­Payment triggers. Sensors automatically notify the smart contract when a container has reached a predefined geographical location which has been agreed by the parties as the trigger for payment. The smart contract receives the information from the container, verifies it and releases payment from an escrow account to the seller;
  • ­Inventory / distribution management. Again using smart contracts and GPS location sensors, each party in the supply chain can see what goods they have where. Whether this is a manufacturer seeing what stocks he has and where they are located, or a haulage company seeing how many client collections they have to complete, or a buyer knowing what is in his warehouse and when he needs to order more;
  • ­Product tracing for consumers. With each consignment having its own tracking number and the ability to trace it through the supply chain from manufacturer to consignee, consumers can check to see if the products they are buying have been ethically sourced or are counterfeit (a particularly big problem in the pharmaceutical industry in developing countries);
  • ­Real time cargo tracking through the supply chain. As part of the transparency achieved by smart contracts, this information would be available to all stakeholders. It is thought that this level of transparency would assist with cutting down port calls (and therefore demurrage) as these would be better timed. Customer expectations could be managed with early warnings of unforeseen events which could cause a delay; and
  • ­Monitoring temperature sensitive cargo. Sensors attached to food products or the inside of reefer containers can constantly monitor the conditions in real time to ensure that they are kept as per the agreed contractual parameters.

All these practical applications of smart contracts seek to improve efficiency, reduce costs and provide a greater customer service through the whole supply chain.

Legal considerations

Smart contracts, however, should not be thought of in the traditional sense of the term “contract”, i.e. a set of legally binding obligations and rights of the parties to the contract. That said, if the requirements for a valid contract are contained in a smart contract, then there is nothing preventing it from being legally enforceable.

Under Hong Kong law, there are 5 elements which are required in order for a contract to be considered legally binding between parties. Namely; intent to be legally bound, offer, acceptance, consideration, and capacity to enter into a contract. The smart contract would need to capture all of these elements in order to be legally enforceable.

Consideration should also be given as to the law and jurisdiction which governs the terms of the smart contract. Smart contracts on a distributed ledger could have multiple copies in multiple jurisdictions. Unless agreed between the parties, the international nature of the smart contract could result in a conflict of laws dispute in the event an issue arose.

A legal contract between two parties often contains clauses which would not fit into the “if x then y” logic of a smart contract. Furthermore, some clauses in contracts are often drafted with deliberate vagueness so that they have a wide interpretation. These contractual nuances would not transfer into a smart contract, which very much relies on absolutes in order to function.

In light of these potential issues, there has been much discussion over the use of “hybrid contracts” where, for example, the obligations which are able to be coded are contained in the smart contract and those that require “human” interpretation in a natural language contract. Take for instance, an overarching master services agreement which contains clauses such as price increases to be discussed in good faith, with the operative parts (i.e. recording deliveries and executing payments) being contained in a smart contract. How the two will interact when it comes to a legal dispute is yet to be seen.

­Reduced costs
By digitally automating many of the paper-based functions and removing middlemen (e.g. brokers, warehouse verification workers etc.) the cost of transporting a cargo is considerably decreased. CargoX (an electronic bill of lading provider) estimates that the average paper bill of lading courier costs are USD 100 per document.
­New technology
Companies will need to check to see whether the existing technology they have is compatible with the new technology required to fully execute a smart contract. For example, is the freight forwarders’ current container tracking equipment able to digitally interact with the smart contract code without any human interference? Or would it require a certain level of human input? If new technology is required, this could be an expensive up front cost. Furthermore, companies will need to bear in mind what the ongoing subscription costs for smart contract software would be.
­Reduced errors
The use of real time distribution ledgers are thought to reduce human errors in documentation as they are verified by all parties involved and once added into the smart contract, cannot be changed. In addition, through the constant monitoring of the consignment any variations to the agreed terms of carriage can be picked up sooner rather than later.
­Code language
Smart contracts are written in computer code. This is a niche skill and one which most businesses will not have in house. Parties go to lawyers to draft contracts who are experienced and will ensure that the parties’ intentions are accurately reflected. The contract can then been read by both parties to verify its contents. Computer code is a different language, and unless both parties are fluent in the code, then it is unlikely that the parties will be able to review this for themselves and ensure that it has captured the intended inputs and outcomes.
Smart contracts cannot be stopped once they have been added to the distributed ledger. This gives the various stakeholders comfort that once the pre-set conditions have been agreed the automated obligation will be carried out once the correct inputs are given. For example, once the cargo has reached the agreed location, the smart contract will automatically release payment to the seller from escrow which the buyer had put in at an earlier date. This provides certainty to the seller that they will be paid once they have completed their obligations, the buyer cannot delay payment by alleging faults in the sellers’ performance.
­Inflexibility and limitations
Smart contract are often called immutable. I.e. what has been coded cannot be changed once the smart contract has been entered into the distribution ledger. Therefore if the parties change their mind at a later date, it is not possible to update the smart contract with a change in the conditions.

There are limitations on what a smart contract can be coded to do. As discussed above, the code works on a “if y then x” basis. Therefore, if the agreement between the parties allows for an adjustment of price that is to be negotiated at a later date, this cannot be coded into the smart contract. The smart contract would not be able to execute an instruction that “if y then the parties are to mutually agree a price variation”. In this situation, there would need to be a natural language contract as well.
­Reduced legal disputes
“The code is law” is the view of some technologists. The idea being that the smart contract will only carry out functions that it has been programmed to do. There is no human initiative to suddenly breach the contract as they no longer feel like complying with the obligations. It is also likely the information contained in the consignment documents are more accurate leading to less disputes between the parties.
­Increased legal issues
As discussed above, issues could arise from smart contracts as to their enforceability and jurisdiction and governing law status. Another consideration could be if the law changed which made the obligations coded unlawful, how would the parties be able to amend the smart contract to allow for this? Furthermore, smart contracts could essentially take away some of the legal remedies such as the ability to interrupt the performance of contractual obligations, or to rescind the contract.
By coding smart contracts in to distributed ledgers, the technology provides a secure environment for the information contained in the smart contract, lending itself to the description “tamper-proof”. This decreases the risk of fraudulent information being inputted into say a bill of lading. Any changes that are made are captured in the smart contract’s history and is capable of being audited. In addition, all inputted information needs to be verified before it is implemented which can catch out any fraudulent amendments to the information.
Whilst many believe that smart contracts provide a more secure way of carrying out a transaction, they are not impervious to hackers. There have been several high profile cases where cyber hackers have been able to write code that exploits weaknesses in a smart contracts code and have transferred a lot of the stored currency to the hackers.
­Increased efficiency and transparency
By cutting out the middlemen and paper based documents, time is saved. All stakeholders have access to the information in real time and can update it with the relevant inputs (such as accepting a delivery), this gives overall transparency to the progress of a shipment.
­All conditions must be met.
A smart contract will not self-execute unless all the pre-programmed conditions have been met. Therefore parties need to think carefully about what is agreed to be locked into code and if it is achievable.

With the technology of smart contracts and distributed ledgers still in the relatively early stages of development, there are of course many drawbacks to consider along with the positives. The application of this technology in the logistics industry is being slowly trialled with companies appearing to favour a staged roll out to specific parts of the supply chain rather than tackling the whole journey in one go.

Article authors:

Nicola Tune