The world of legal contracts is changing. A month ago Barclays used blockchain-based trade finance and bills of lading documents to complete an international transaction. It was a world first for a major bank and a small but important experiment to move away from physical contracts.
This week the news broke that this blockchain-based type of trade transaction had been taken one step further by embedding a GPS device into a shipment (in this case bales of cotton) that was linked to a smart contract. The GPS sent a signal when the goods arrived at the right location, in turn triggering the trade contract to self-execute. The deal was organised by the Commonwealth Bank of Australia, Wells Fargo and Brighann Cotton.
Again, another small, but very important, step forward that this time integrated the Internet of Things (IoT), in this case the GPS device, with a digitally-based contract.
And, earlier this year legal tech start-up, Clause, produced the world’s first ‘IoT-enabled’ legal contract. This was demonstrated to Dentons and took the form of a data-augmented natural language supply agreement. Or in other words, a legal contract that responded to external information that was fed into it. The company is able to talk about it now following their announcement of an investment deal from Nextlaw Labs and Seedcamp earlier this month.
This new kind of contract is distinct from a blockchain-based ‘smart contract’ . In Clause’s test case they designed a supply agreement connected to an IoT platform that fed the contract humidity and temperature data.
The data feed was designed to monitor any breach conditions of the contract and provide dynamic pricing of the goods as they travelled. I.e. the contract changed the price of the goods as external conditions had an impact on them (see below).
The Clause legal contract also auto-reconciles with accounting and invoicing software in real-time (e.g. Xero’s accounting software shown in the example above).
These are early days for dynamic contracts, though some of the immediate uses would be in connection to logistics, insurance, asset-backed finance, derivatives, commodities and trade, but there are likely to be many other uses to be explored. In effect this is a new era for IoT-enabled dynamic legal contracts that has only just begun.
The following piece was provided by Peter Hunn, Co-founder and CEO of the New York-based start-up. It sets out some of the key ideas around Clause’s work and their vision for the future of legal contracts.
At Clause we are building the future of legal contracting: an architecture that enables contracts to be driven by and connected to real-time data, and able to manage themselves.
Essential to our vision is that contracts should be dynamic , i.e. their terms and conditions should adjust over time by responding to the state of the physical world they aim to govern. Contracts should be living, breathing parts of digital ecosystems, not a roadblock to business automation.
Companies want dynamism in their contractual relationships yet today contracts remain generally static, which is a problem that Clause is fixing. To the extent companies bring dynamism into their contracts right now, they do so by pre-specifying the ways terms change and by leaving room for clarification or renegotiation.
While these low-tech methods are useful, they are fundamentally limited, resource intensive, costly, and expose parties to unnecessary risk.
Prespecified Contract Dynamism
Contracts are dynamic when prices, interest rates and other terms are drafted to change in prespecified ways in response to the state of the parties’ relationship, the condition of a party, or the physical world.
For example, in this metal can supply agreement, the price for any particular purchase is based on the volume of goods ordered and the supplier’s own costs (e.g., the costs of ingot). And in this Intel supply agreement, the price owed is reduced if the goods are delivered late or the seller charges the buyer more than it is charging its other customers (known as a ‘most favored nation’ clause).
Most corporate loan agreements have ‘performance pricing’, meaning that the interest rate charged varies depending on some measure of the borrower’s financial performance, such as their credit rating or debt-to-equity ratio. Likewise, the amount of credit available to a borrower under an asset-based loan typically changes monthly, if not more often, based upon the value of the borrower’s inventory and accounts receivable.
Of course, a wide variety of commonplace contract terms have some kind of built-in dynamism, such as credit cards interest rates that increase if a borrower misses payments. This kind of built-in dynamism is also becoming more prevalent and being driven by data.
As recently noted by Insurance Networking News: ‘Constant data from IoT devices mean that insurers can update prices accordingly , both up and down, as risk is better quantified. Seventy-seven percent of auto insurers surveyed expect policies to be priced dynamically in five years.’
At Clause, we’re making the contracting infrastructure for these types of dynamic relationships available for the first time.
Dynamism Through Clarification and Renegotiation
Dynamic contracts also come about when the actual terms or specifications of the contract are later clarified or renegotiated.
As noted in a 1992 Columbia Law Review article, parties often form contracts with open terms that are later clarified to preserve flexibility over the course of their relationship. Oliver Hart and Bengt Holmström won the 2016 Nobel prize in economics for helping us understand these ‘incomplete contracts’.
Contracts may also expressly permit their terms to change. Many ‘freelance’ agreements, for example, permit the client to request new services with the compensation and delivery schedule to be redetermined accordingly. Contracts may also reserve the right to renegotiate on-the-spot if product specifications are not met or a force majeure event takes place.
Long-term supply agreements often contain ‘price re-openor’ clauses that allow either party to renegotiate the price every several years, or if a reference price changes. Likewise, contracts to develop a new product are fraught with uncertainty, and parties are well-advised to ‘reserve the right to renegotiate price, timing, and warranty and indemnification terms’.
Dynamic contracting through renegotiation also takes place even if the contract does not expressly reserve the right to renegotiate. For example, one study found that 76% of public companies’ loans were renegotiated before maturity. Indeed, contract researchers have noted for decades that renegotiation often plays an important role in unlocking value for both sides by better aligning the parties’ relationship to new circumstances.
As the this shows, companies already yearn for dynamism in their contracts and commercial relationships. That’s why at Clause we are meeting that desire and amplifying it with a new paradigm that automates and broadens the dynamics of contracts and commercial relationships far beyond what is currently possible.
Our technology enables legal contracts to dynamically change their state in response to changes in the physical world (ranging from machine health to weather patterns) and business analytics such as industry benchmarks and spending projections.
Doing this allows parties to bring flexibility and real world connectivity to a far greater range of contractual terms and relationships. Dynamic contracts also reduce the need for parties to have to renegotiate in the first place and thereby reduces the associated risk and costs.