Smart contracts: Meaning, application, and enforceability

With the advent of Artificial Intelligence automation seems to be the future. Law is not untouched by this revolution. However, once automation is applied in the field of law it raises new questions. Smart contracts are one such instance of automation.

As most of the laws were made to be applicable to manual and human transactions and not automated and artificial intelligence-based transactions, thus, the application of archaic laws onto modern technology is terra incognita.

Meaning

“Smart contracts” is a term used to describe computer code that automatically executes all or parts of an agreement and is stored on a blockchain-based platform.[1] The code facilitates, executes, enforces negotiations, and performs the terms of the agreement.

The functioning of smart contracts is enabled by blockchain technology. The use of blockchain technology allows it to remain decentralised, thus providing it a distinct nature from traditional contracts. Basically, any contract is a smart contract if they store rules, verifies rules, and is self-executing and runs in a decentralized manner.[2]

The essentials of a smart contract are the following-

1. Decentralised- The rules and information regarding the contract are stored in blockchain technology. These are the nodes of stored data. Thus, decentralising the information into several data blocks or nodes.
2. Self-Executing- Smart contracts are self-executing in nature which means that no human intervention would be required in order to execute the contract. This makes smart contracts a better option as compared to traditional contracts. As it eliminates the inefficiency that human intervention brings in the execution of the contracts.
3. Irreversible- Smart contracts are irreversible in nature. Essentially smart contracts are a piece of programmed coded logic, thus once the execution of the contract is set in motion it can not be reversed. It can be stated to be one of the drawbacks of the lack of human intervention.
4. Unalterable- Smart contracts are based on blockchain technology. Once a data block is created it can not be altered further. If the parties intend they may set up a new smart contract, however, any alteration in an existing smart contract is not possible.

In simple words, a smart contract can be compared to a computer or a vending machine. With the right inputs, a certain output is guaranteed. A smart contract, like a vending machine, has logic programmed into it. Like how a vending machine removes the need for a vendor employee, smart contracts can replace intermediaries in many industries.

Advantages

Cost efficient- Smart contracts aim to eliminate the need for intermediaries between the parties of the contract. Thus, it eliminates the cost of brokers and other such intermediaries. Hence, in industries that traditionally depend upon brokers, a smart contract may provide a much more cost-effective alternative.

• Document Safety and Confidentiality- The documents and details of the contract are safer in a smart contract as compared to traditional contracts. Smart contracts are encrypted, and cryptography keeps all the documents safe from infiltration[3]. As the data is stored in blockchain and is unalterable. It also keeps the details of the contract confidential.
• Speed- As the smart contracts are self-executing in nature and there is no human intervention involved so, the execution of the contract would be instantaneous with the fulfillment of the pre-requisite conditions.
• Accuracy- Human intervention can cause errors in execution of contracts. However, coded software follows a pre-set algorithm thus, there is no scope for errors.

Disadvantages

• Unalterable- Smart contracts are unalterable in nature. As a result, any error in the coding may result in unstoppable loss. Under a traditional contract, the parties may renew the terms of the contract with mutual consent, however, in the case of smart contracts its not possible to do the same.
• Possibility of loopholes- According to the concept of good faith, parties will deal fairly and not get benefits unethically from a contract. However, using smart contracts makes it difficult to ensure that the terms are met according to what was agreed upon.^[4]
• Difficult to understand- Smart contracts often require the help of software experts to understand the terms and alter the code. This again leads to the involvement of a third party thus, increasing the cost.

Application

Smart contracts have a very wide ambit of usage. The list of its application is non-exhaustive. Following are some real-world use cases of smart contracts:

• Cross-border liquidity of financial assets- Smart contracts can alter the trade finance industry as well. There is no question that using a Letter of Credit can aid in international commodities transfers and trade payment initiations.

Using smart contracts would undoubtedly increase the liquidity of financial assets, which will enhance the financial efficiency of suppliers, purchasers, and institutions. With proper integration, it can surely solve legal complications and offers a better way to solve disputes among parties.[5]

• Improve financial services- If smart contracts are deployed to render financial services like loans and mortgages then the whole process will become frictionless and will be less cumbersome for the parties.

For instance, in the case of a mortgage smart contracts may seamlessly track the payments made and release the property as soon as the debt is repaid. This saves the time of the parties involved as well as reduces the scope of error.

• Insurance- Smart contracts may be utilised along with other technologies like the internet of things to settle insurance claims within minutes. Thus, reducing the lag that is faced as a result of human intervention.
• Document Preservation and Accessibility- Certificate and document forgery has been a significant issue individuals and institutions have faced for years. Physical and digital documents are prone to loss, and there are often no means to authenticate certificates quickly without contacting the issuer, which is a lengthy process.

In cases where timely and secure authentication is required, smart contracts can help eliminate the complexities of the process, ensuring the authenticity of a certificate or document using the explorer of the underlying distributed ledger technology (DLT).[6]

Administrative payments- Use cases for smart contracts in administrative payments and billing include:

• Payrolls
• Taxation
• Pensions
• Insurance
• Bill payments[7]

Status under Indian law

Enforceability under the Indian Contracts Act, 1872

For an agreement to be a contract, it must be enforceable by law.[8] To be enforceable the contract must have a valid offer, acceptance and consideration and it must fulfill the requirements under section 10 of the Indian contracts act. A smart contract satisfies all these conditions.

Valid offer- When one person signifies to another his willingness to do or to abstain from doing anything, with a view to obtaining the assent of that other to such act or abstinence, he is said to make a proposal.[9]

In a smart contract, the language of the self-executing code shall indicate the existence of an intention to contract with another party, and the act of publishing that line of code for a single smart contract on any blockchain would amount to the communication of an offer.[10]

• Valid acceptance- Next, the assent, of another party, to the terms outlined in an offer amounts to acceptance of that offer.[11] Such acceptance could also be derived from the language of the self-executing code, as the input by the party involved amounts to assenting to the consequence of the execution of the programmed code on the given input, thus amounting to accepting the terms of the contract.
• Valid consideration- As per the Contract Act, consideration includes any act done for the benefit or interest of a party, or maybe qualified by some detriment or loss suffered by the other party.[12] In the context of a smart contract, given that only if/when the actions outlined in the code is carried out, only then shall the contract be executed.
• Free consent- Further, the Contract Act states that “all agreements are contracts if they are made by the free consent of parties competent to contract, for a lawful consideration and with a lawful object, and are not hereby expressly declared to be void.”[13]

Given that smart contracts may only be executed when the predetermined conditions envisaged and encapsulated under the code are met, the parties seeking to enter into an agreement under that smart contract would thus have to have consented to the execution of the terms of for the code (or smart contract) and thus would have agreed to enter into that contract.[14]

Thus, it can be deduced that it a smart contract can be made within the ambit of the Indian Contracts Act. Thus, the relevant provisions of the Indian Contract act can be used to regulate smart contracts.

The IT Act 2000

In the context of digital contracts section 35 of the act is relevant. Section 35 provides that digital contracts are valid contracts provided, they have a Digital/Electric certificate of the Certified Authority authorised by the government.

However, this requirement of Digital/Electric certificate of the Certified Authority authorised by government is fundamentally averse to the very nature of smart contracts. Smart contracts function on the basis of blockchain technology which has a decentralised structure.

However, it should be considered that doesn’t specifically bar the authentication done by the blockchain technology it only approves the digital signature of certified authorities.[15]

The Evidence Act 1882

Section 65B of the act deems digital contracts to be admissible evidence in court. However, such admissibility is subject to the condition that the said contract must have a digital certificate by the authority to prove its authenticity as mentioned in section 85B.

Conclusion

Every business desires to be more and more efficient while reducing or maintaining the cost. Both of these can be achieved by the tools of automation and smart contracts. Thus, the increased use of smart contracts in various industries can not be ignored. The present statutes were not made to regulate smart contracts.

Thus, their application of the same often leaves a lacuna that needs to be addressed. Thus, it’s high time to bring clarity on the status of smart contracts in India. This clarity would lead more firms to adopt these solutions, thus allowing growth and technological advancement of industries.

References:

[1] https://corpgov.law.harvard.edu/2018/05/26/an-introduction-to-smart-contracts-and-their-potential-and-inherent-limitations/

[2] https://www.india-briefing.com/news/what-are-smart-contracts-and-are-they-legal-in-india-25343.html/#:~:text=The%20Indian%20context,valid%20contracts%20under%20Indian%20law.

[3] https://corporatefinanceinstitute.com/resources/valuation/smart-contracts/

[4] Ibid.

[5] https://101blockchains.com/smart-contract-use-cases/ .

[6] https://blog.logrocket.com/examples-applications-smart-contracts/ .

[7] Ibid.

[8] Section 2(h) of The Indian Contracts Act, 1872.

[9] Section 2(a) of The Indian Contracts Act, 1872.

[10] https://www.mondaq.com/india/fin-tech/1133130/smart-contracts-in-india#:~:text=Today’s%20smart%20contracts%20are%20programs,then.%22%20commands.

[11] Section 2(b) of The Indian Contracts Act, 1872.

[12] Section 2(d) of The Indian Contracts Act, 1872.

[13]  Section 10 of The Indian Contracts Act, 1872.

[14] https://www.mondaq.com/india/fin-tech/1133130/smart-contracts-in-india#:~:text=Today’s%20smart%20contracts%20are%20programs,then.%22%20commands.

[15] https://www.legalserviceindia.com/legal/article-8128-overview-on-smart-contract-indian-law-perspective-and-mechanism-of-dispute-resolution.html.

This article has been authored by Ayush Upadhyay, a student at Chanakya National Law University.