Frederick D. Cruz and Seth Wamelink | Construction Executive | November 4, 2019
In August 2018, the State of Ohio passed legislation making it easier for businesses in Ohio, including the construction industry, to use blockchain technology in business transactions, which can result in significant savings and increased efficiency if used correctly. Specifically, Senate Bill 220 amends the Uniform Electronic Transactions Act (Ohio Rev. Code. 1306.01, et seq.) and ensures that records (or signatures) secured through blockchain are legally binding. With the enactment of this bill, Ohio has joined several other states to allow their businesses to take advantage of this budding technology. While the implications of this enactment are widespread, the use of “smart contracts” utilizing blockchain technology is particularly helpful in the construction industry to streamline certain processes and increase efficiency.
WHAT IS BLOCKCHAIN?
While blockchain technology is most commonly associated with cryptocurrency (e.g., Bitcoin), the technology has far greater applications as it can be used to “eliminate the middle-man” in a variety of transactions across a broad spectrum of industries. At its core, blockchain is a decentralized ledger that allows transacting parties to interact directly (i.e., peer-to-peer) in a secure manner. Essentially, the blockchain “ledger” is where users record transactions. These transactions are then verified, viewed, and shared with others in the network. The information is stored across a peer network and allows for approved users to view the data simultaneously. It is often analogized to using GoogleDocs, where multiple people can access and edit the same document simultaneously. While that is an easy comparison, blockchain itself is a bit more complex.
This decentralized system allows for greater security as the information—or the chain of information stored in the “blocks”—is less susceptible to breaches or hackers. It also provides a mechanism for validation of the information and prohibits previous blocks (or data inputs/information) from being tampered with or modified. As even smaller construction projects are becoming increasingly reliant on electronic data, cybersecurity is a large and often underappreciated risk, which blockchain can help mitigate. Indeed, cities across the nation are looking to blockchain as a means to improve efficiency and restore public trust, which includes using the underlying technology to develop “smart contracts.” Smart contracts can be especially useful in the construction industry.
A smart contract is a “self-executing” electronic agreement. It is still a contract, which at its core is a compilation of terms and conditions that govern the relationship between contracting parties. Smart contracts simply streamline this process by enabling the automatic enforcement or execution of certain terms/provisions upon the happening of a condition precedent, i.e., a predetermined event. The functionality of the smart contract is often explained in terms of an “if/then” occurrence: If X occurs, then Y happens. The automation is what makes this tool efficient and revolutionary. In short, the contractual provisions are encoded within the electronic contract using an algorithm, and the contract is recorded onto the blockchain. From there, as previously agreed upon condition precedents begin to occur, the smart contract automatically begins executing the terms of the contract.
Importantly, smart contracts do not foreclose the use of standard provisions/clauses, such as in AIA contracts or ConsensusDocs, but rather the execution of certain provisions becomes automated. Moreover, not every term or condition of the contract is “coded” or automated. Standard provisions can and must remain. Rather, the substantive provisions are the terms that stand to benefit most from smart contracts (e.g. submittals, payments, scheduling, etc.). Once the provisions of the smart contract are agreed upon, the blockchain can take over.
With a growing shift to adopting and integrating this technology into construction projects, it is important to understand how smart contracts can be used to your advantage and streamline your business. A common use of smart contracts is to include provisions where the completion of certain activities trigger automatic payment from an escrow account where project funds are held. The triggering event could be application for payment approval, substantial completion, actual completion, warranty walkthrough, acceptance, etc.
For example, Prime Contractor needs 100,000 tons of gravel for its project to be delivered periodically in 100 ton increments. Prime Contractor can utilize a smart contract with Supplier to set up an automated process wherein a delivery of materials is automatically scheduled upon depletion of the current stocked materials. Taking this a step further, Prime Contractor could install sensors to monitor the inventory and automatically schedule deliveries once inventory drops below a certain level. The administrative tasks are therefore completed electronically and through a secured blockchain. This administrative automation leads to further efficiency in time, cost and use of resources (both human and physical).
POTENTIAL DRAWBACKS AND BEST PRACTICES
It is important to know the basics of blockchain and smart contracts before being faced with them for the first time on an upcoming project. Negotiation of these contracts are just as, if not more, important than a typical contract because some items of work do not lend themselves to automation as well as others. Blockchain has many benefits, but as with any new technology, it has unique drawbacks and risks. For example, the use of a smart contract cannot eliminate the potential for human error when executing or inputting triggering events. One way to minimize any such risks is assuring that the smart contract, and underlying software, affords the parties the opportunity to retroactively correct, or claw-back, any inadvertent mistake that results from automation, particularly regarding payment. This allows your company to determine the best and most efficient use of this technology while minimizing the risk inherent with smart contracts. There is no question that this technology can lead to greater efficiency and, thus, greater profits, but it is important to negotiate any smart contract in a way that minimizes any risks posed by automation.