This article has been written by Oishika Banerji of Amity Law School, Kolkata. This article discusses the concept of smart contracts which is generally a program that is stored with the help of blockchain technology and runs when predetermined conditions are met.
This article has been published by Sneha Mahawar.
A smart contract is a self-executing contract in which the conditions of an agreement between a buyer and a seller are directly encoded into lines of code. The code, which contains all of the agreement provisions, is stored in a distributed, decentralised blockchain network. The code also contains information that executes transactions and ensures that they are monitored and irreversible, in addition to the agreements. As a result, a smart contract can be defined as a type of computer protocol that digitally performs the functions of facilitation, verification, and enforcement, that is contract performance. A smart contract does not rely on the state for enforcement but is a way for contracting parties to ensure performance.
What is a smart contract
Smart contracts are digital transaction protocols that use the blockchain to autonomously enforce an agreement without the need for a third party. The conditions of the agreement are written in computer codes, and they contain restrictions and penalties that both parties must agree to before signing. Transactions conducted in this manner are immutable and transparent, allowing all parties involved to audit and confirm data as needed. The following are the main characteristics of a Smart Contract:
- No one, including the author or owner, may change the conditions of a Smart Contract once it has been released.
- The contract’s execution and conclusion do not necessitate the submission of any physical documents.
- The transaction data is logged and registered, even if the user is anonymous.
- Smart Contract transactions are irreversible.
The basic vending machine is a classic example of a Smart Contract. A contract for sale will be automatically completed if the machine is running properly and money is placed into the machine. If the machine were to dispense Pepsi, there would be no legal issues; however, if the machine were to dispense heroin, there would be legal issues.
How do smart contracts work
- The contract’s code is made up of the provisions of the contract in question. Smart contracts interpret, verify, and execute any transaction that is in accordance with the terms.
- Let’s look at an example of a rent contract that has been converted into a smart contract to understand how efficient and effective a Smart Contract can be. The tenant will pay the rent in cryptocurrency to the house owner, and once the payment is received, the code will carry out the transactions according to the parameters of the contract as entered into the code. When the transaction is completed, the homeowner will receive a receipt and the key to the house will be released. The system works on the If-Then principle, which means that hundreds of people who are part of the blockchain will be able to see the transaction and witness the contract. If the homeowner hands over the key, he will undoubtedly be compensated. If the tenant pays the rent, he will very certainly be given the key. One operation cannot be accomplished without the other, resulting in a system that is both efficient and effective.
- Smart contracts, like traditional contracts, specify the rules and penalties that apply to an arrangement, but they also carry out those responsibilities automatically. The Ethereum platforms, which consists of two elements, namely, currency and contracts, are used to construct these contracts.
- Smart contracts are contracts in which the interaction medium is switched from paper to an electronic platform. This raises the question of whether smart contracts can still be governed by existing legal frameworks or if they need to be governed by a new legal system.
- Revocation and modification costs are expensive for strong smart contracts, but not for weak smart contracts. This indicates that if a court can easily change a contract after it has been executed, it will be classified as a weak smart contract. If changing the contract in a way that would not make sense for a court would be prohibitively expensive, the contract will be deemed strong.
- The beginning stages of a contractual arrangement are similar in both smart and traditional contracts. This is because, in order for the contract to work, two parties must agree to a set of terms that kicks off the programme. Unlike traditional contracts, acceptance in the world of smart contracts is based on performance. A person can declare they will start a smart contract, which may be a legal contract, but there is no smart contract until the programme starts. However, a smart contract code can be added to a ledger as an offer.
- The contract is made once an action is taken to initiate acceptance, such as giving the code power over a particular amount of money.
- Smart contracts have the ability to formalise the situations in which courts will enforce contracts. This is because the smart contract’s terms are clearly stated, and each party’s obligations and advantages are readily obvious.
- Smart contracts make the performance phase easier since they provide a solution for resolving ambiguity issues. Imperfect performance, on the other hand, could be an issue.
- In the United States, perfect performance is not required for a contract to be recognised and enforced. Even if the performance does not fully comply with the precise terms given out, the common law notion of substantial performance allows a contract to be recognised.
- Normally, computer programmes are created with the capability of adding code later. Only contracts including some type of irrevocability would compel courts to intervene. This is due to the fact that a court would be tasked with enforcing a law that would overrule the contract’s provisions, there would be contradictory directives. In state-based legal systems, party autonomy does not outweigh all other considerations.
Breach of contract and remedies that follow
- The major issue in the last question of contract law is what happens when the smart contract’s outcomes differ from what the law requires. Courts will be more inclined to enforce smart contract provisions since the parties specifically laid out their conditions, giving the courts more assurance about the parties’ intent.
- Smart contract drafters will be more inclined to construct smart contracts that follow current law and include variable provisions to account for future changes in the law. The conditions of a lease, for example, will vary to accommodate the jurisdiction’s property legislation. Ex post enforcement is the favoured system in the United States and other common law systems, and there are numerous reasons to assume that this is a system that promotes greater wealth and vibrancy.
- Some unenforceable contracts result in criminal charges, while others are not enforced at all. At this moment, it’s too early to predict how governments will react to smart contracts because these technologies haven’t matured to the point where they require government intervention. Individuals may not want to change their current contracting patterns because they are comfortable with the level of leeway and uncertainty that exists now, therefore they may not reach this level.
Historical background of smart contracts
Nick Szabo, a computer scientist and cryptographer, and doctoral student at the University of Washington, coined the term “smart contract” approximately 20 years ago. When comparing smart contracts to paper-based contracts, Szabo’s usage of quotes around the word “smart” and his eschewing of artificial intelligence is significant. Smart contracts are “smarter” than paper contracts in that they can execute certain pre-programmed actions automatically, but they should not be viewed as sentient instruments capable of parsing a contract’s more subjective criteria. A vending machine is, in fact, Szabo’s basic illustration of a smart contract. When a customer meets the contract’s conditions (i.e., inserting money into the machine), the system automatically honours the unwritten agreement and delivers the snack.
Ricardian Contracts, a notion established in 1996 by Lan Grigg and Gary Howland as part of their work on the Ricardo payment system to transfer assets, is another notable source of smart contracts. Ricardian Contracts, according to Grigg, are a bridge between text contracts and code that has the following characteristics, a single document is;
- The contract offered by an issuer to holders,
- For a valuable right held by holders, and managed by the issuer,
- Easily readable by people (like a contract on paper),
- Readable by programmes (parsable like a database),
- Digitally signed,
- Carries the keys and secure identifiers.
Types of smart contracts
Smart contracts can be roughly classified into three primary categories:
- Smart legal contract: A smart legal contract, the most common type of smart contract, has similar legal requirements to its traditional counterpart (i.e., mutual assent expressed by a valid offer and acceptance, adequate consideration, capacity; and legality), and it is used to hold concerned parties accountable for fulfilling their end of an agreement. When correctly set up, a smart contract is legally binding and requires the parties to fulfil their duties. Failure to do so may result in legal action being taken against the party who is in violation, which can be immediately triggered by the smart contract.
- Decentralised Autonomous Organisations: DAOs, or Decentralised Autonomous Organisations, are communities that live on the blockchain. These communities can be defined by a set of mutually agreed-upon rules that are codified using smart contracts. Every participant and their acts are subject to the community’s rules, and the duty of enforcing these rules falls to the community’s rules enforcers. These rules are made up of numerous smart contracts that work together to monitor community actions.
- Application Logic Contracts: Application Logic Contracts, or ALCs, are blockchain contracts that incorporate application-based code that keeps up with other blockchain contracts. They allow communication between multiple devices, such as when the Internet of Things (IoT) and blockchain technology are combined. ALCs are a critical component of multi-function smart contracts, and they are often managed by a programme.
Role of smart contracts in finance
There are inherent benefits to smart contracts when it comes to finance. The same has been highlighted below:
- Investment banking: Corporate clients could profit from quicker settlement cycles in the trading and settlement of syndicated loans. Smart contracts could reduce this time by 6 to 10 days instead of the current 20 days or more. This could result in an additional 5% to 6% increase in demand in the future, resulting in increased revenue of between US$2 billion and $7 billion per year. Operational costs for investment banks in the United States and Europe would also be reduced.
- Retail banking: Smart contracts will have a huge impact on the mortgage loan business. By cutting processing costs in the origination process in the United States and European markets, consumers might save between US$480 and US$960 each loan, and banks could save between US$3 billion and $11 billion yearly.
- Insurance: The use of smart contracts in the personal car insurance business alone might result in yearly cost savings of US$21 billion due to automation and lower claim processing overheads. Insurers may also pass on a portion of their annual savings to consumers, resulting in cheaper premiums.
Are smart contracts reversible
Smart contracts are computer-assisted procedures for verifying and enforcing contracts. Smart contracts do not require any third parties because they do away with the necessity for manual intervention. Everything is digitally constructed, and smart contracts are irreversible. These transactions are not only traceable, but they are also irreversible. A smart contract is a piece of software that is self-enforcing and controlled by a peer-to-peer network of computers.
Smart contracts and cryptocurrency : the road ahead
Ethereum applications are built on the foundation of smart contracts. They are blockchain-based computer applications that allow us to convert traditional contracts into digital counterparts. Smart contracts are quite rational, as they follow an if/then pattern. This means they follow the programme exactly and cannot be modified. Participants’ agreements to selectively disclose or conceal information are crucial to the operation of cryptocurrencies like Bitcoin.
According to various viewpoints, the agreements amount to a broad multilateral contract to which all parties are a part. Smart contract technology ensures that the multilateral agreement is automatically enforced. As a result, cryptocurrency “wallet holders” are both creditors and debtors to their cryptocurrency community when it comes to smart contract claims.
Objectivity and the limits of incorporating desired ambiguity into smart contracts
Smart contracts’ objectivity and automation requirements may conflict with how business parties really form agreements. Parties engage in an implicit cost-benefit analysis during talks, recognising that there are decreasing returns in trying to anticipate and solve every imaginable circumstance. These parties may no longer wish to invest management time or legal fees in negotiations, or they may decide that starting revenue-generating activity under a signed contract is more important than resolving outstanding difficulties. Instead, they can decide that if an unexpected incident occurs, they will find a solution at that time.
Similarly, parties may choose to leave a clause in an agreement relatively unclear to provide themselves the flexibility to argue that the provision should be read in their favour. Smart contracts make this approach to contracting more challenging since computer code necessitates a level of precision not present in text-based contract negotiations. There cannot be any confusing phrases in a smart contract, and certain hypothetical eventualities cannot be left unanswered. As a result, parties to smart contracts may discover that negotiating sophisticated smart contracts has higher transaction costs than standard text-based contracts.
It will take time for people implementing smart contracts in a certain industry to figure out which requirements are objective enough to support smart contract execution. As smart contracts get more complicated, parties may differ over whether a certain contractual provision can be captured by the objectivity, which is required by a smart contract.
Advantages of smart contracts
The list of advantages of smart contracts have been provided hereunder:
A digital vending machine
A vending machine is a simple metaphor for a smart contract since it functions in a similar way to a smart contract in that particular inputs guarantee certain outcomes.
- You select a product.
- The vending machine returns the amount required to purchase the product.
- You insert the correct amount.
- The vending machine verifies you have inserted the correct amount.
- The vending machine dispenses the product of choice.
Only once all of the prerequisites have been completed, will the vending machine distribute your preferred goods. The vending machine will not give you your product if you do not select it or insert enough money.
With traditional contracts, one of the most common points of failure is the human aspect. A typical contract, for example, may be interpreted differently by two different judges. Their interpretations may result in different decisions and different outcomes. Different interpretations are eliminated with smart contracts. Smart contracts, on the other hand, execute precisely according to the conditions contained in the contract’s code. This precision means that the smart contract will generate the same output under identical conditions.
The automated nature of smart contracts
One of the most important features of smart contracts is their capacity to perform transactions automatically and without the need for human interaction. However, this automation, as well as the fact that smart contracts cannot be readily altered or cancelled unless the parties provide such capabilities during the smart contract’s construction, are two of the most significant barriers to widespread smart contract adoption. In typical text contracts, for example, a party can readily explain a breach by failing to enforce the appropriate sanctions. If a valued customer is one month late with a payment, the vendor can decide in real-time that maintaining the long-term commercial relationship is more vital than any available termination right or late charge.
If this relationship had been reduced to a smart contract, the option of not enforcing the agreement on an ad hoc basis would almost certainly have been eliminated. If the smart contract was designed to do so, a late payment will result in the automatic deduction of a late fee from the customer’s account or the suspension of the customer’s access to a software programme or an internet-connected gadget. As a result, the automatic execution provided by smart contracts may not correspond to how many organisations work in the real world.
In a text-based contractual relationship, a party may be willing to accept partial performance as full performance on an ad hoc basis. This could be because of a desire to maintain a long-term relationship or because a side believes that partial performance is preferable to none at all. The objectivity necessary for smart contract programming may not reflect the facts of how contracting parties interact here, as well..
Smart contracts can also be used for auditing and tracking purposes. Anyone may instantaneously trace asset transactions and other associated information since Ethereum smart contracts are on a public blockchain. You can, for example, check to see if someone has transferred money to your address or not.
Smart contracts can also help to protect our personal information. You can preserve your privacy from observers since Ethereum is a pseudonymous network (your transactions are related publicly to a unique cryptographic address and not your name).
Finally, just like the standard contracts, you can inspect a smart contract before signing it (or otherwise interact with it). Better yet, the contract’s terms are open to public scrutiny, allowing anybody to examine it
Disadvantages of smart contracts
A list of disadvantages of smart contracts has been provided hereunder:
- Difficult to change: It’s nearly impossible to change smart contract operations, and any programming fault can be time-consuming and costly to fix.
- Third-party: Despite the fact that smart contracts aim to eliminate third-party involvement, it is impossible to do so. Third parties have a different role in conventional contracts than they do in traditional contracts. Lawyers, for example, will not be required to prepare individual contracts; but, developers will require their assistance in understanding the provisions in order to generate smart contract software.
- Possibility of loopholes: Parties will deal fairly and not benefit unethically from a contract, according to the principle of good faith. Smart contracts, on the other hand, make it difficult to ensure that the provisions are followed exactly as promised.
- Vague terms: Smart contracts aren’t always able to handle ambiguous terms and conditions since contracts involve terminology that isn’t always understood.
Smart contracts and the law
The establishment of resilient, decentralised, and worldwide platforms is one of the primary promises of blockchain technology, and by extension, smart contracts as well. However, because smart contracts are becoming more widely adopted, parties may be employing them in far more jurisdictions than text-based contracts. The party offering terms under a smart contract would be best served by clarifying the applicable legislation and venue. A governing law clause defines which substantive law will be used for the smart contract’s interpretation, whereas a venue clause provides which jurisdiction’s courts will hear the dispute.
A governing law provision specifies what substantive law will apply to the interpretation of the smart contract, whereas a venue clause specifies which jurisdiction’s courts will adjudicate the dispute. Given the vast range of jurisdictions in which a smart contract might be employed, a plaintiff may be rather unconstrained in deciding where to bring a claim or while arguing which substantive law should apply, in circumstances where controlling law or venue are not mentioned. Provided that many early smart contract disputes may be based on first impressions, contractual parties will desire some assurance about where such disputes will be adjudicated.
The elemental factors of a conventional contract must be met by smart contracts in order to qualify as a valid contract are:
- A legitimate offer,
- A properly communicated acceptance.
- Lawful consideration pertaining to the subject matter.
- Consent of all competent parties in regards to all aspects of the contract.
Are smart contracts enforceable in general
The fundamental distinction between an agreement and a contract must be addressed before discussing the enforceability of smart contracts. Although two parties can engage into a variety of agreements, States generally acknowledge that a contract is one that is legally binding and enforceable in a court of law. State courts have traditionally looked to see if the common law conditions of offer, acceptance, and consideration are met in order to evaluate enforceability. These fundamental requirements can almost certainly be met with supplementary smart contracts. For example, if a flight is delayed for more than two hours, an insurer might construct a flight insurance product that automatically pays out to the insured. The important conditions, such as how the delay is determined, can be specified in a text-based contract, with an ancillary smart contract handling the contract creation (payment of the premium) and execution (automatic payout upon a verifiable delay). The insurer has made a firm offer for a flight insurance product, which the insured accepts in exchange for payment of the premium.
The United States
In the United States, there is no federal contract law, rather, the enforcement and meaning of contracts are decided at the state level. While certain essential principles apply similarly across state lines, and the National Conference of Commissioners on Uniform State Laws has worked to harmonise state laws, any findings of smart contracts must be tempered by the fact that states may take various approaches.
In 1999, the Uniform Electronic Transactions Act (UETA) was enacted in 47 states across the United States. The UETA established rules for electronic contracts, records, and signatures, stating that electronic contracts would be valid and that electronic signatures would be a legal manner to provide contractual assent. The Rome I Regulation is the regulation of the European Union (EU) that establishes the legitimacy of all EU civil and commercial transactions.
Although today, certain contracts must be in writing, and other formalities such as those required by the Uniform Commercial Code (UCC) and state statutes of frauds may be required, agreements do not always have to be in writing to be enforceable. As a result, many code-only smart contracts will be enforceable under state contract laws. In this regard, Szabo’s example of a vending machine is useful. While the customer has several implied rights, no substantial written terms other than a price display for each item were included in the contract. Thus, outside of the hurdles imposed by the UCC and statutes of frauds, the fact that an agreement is represented solely in code, as is the case with code-only smart contracts, offers no specific impediment to contract formation. Indeed, the importance of information technology in contract creation has long been studied by a number of laws and legal structures.
The UK Law Commission, which was established by the Parliament under the Law Commissions Act of 1965 to evaluate and recommend changes to England and Wales law, has initiated a research project on revisions that would make the use of blockchain-based smart contracts legally apparent. Smart contracts, according to the Law Commission, increase “trust and certainty” while also improving business-to-business transaction performance. As a result, in order to improve business and make the current UK legal system adapt to evolving technology.
Similarly, the federal Electronic Signatures Recording Act (e-sign Act) not only recognises the legality of electronic signatures and electronic records in interstate commerce, but also states that a contract or other record relating to a transaction “may not be denied legal effect, validity, or enforceability solely because its formation, creation, or delivery involved the action of one or more electronic agents so long as such action is legal.” The word “electronic agent” refers to a computer programme or other electronic or another automated method that, in whole or in part, initiates or responds to electronic records or performances without review or action by a human at the time of the action or reaction.
While knowing the current legal framework is necessary for assessing the enforceability of smart contracts in present times, persons who use smart contracts in the future may not need to rely on laws that predate the creation of blockchain technology. Arizona and Nevada have already changed their state versions of UETA to include blockchains and smart contracts expressly. The fact that these governments have chosen distinctly diverse meanings of those important terms means that as additional jurisdictions follow their lead, demand to adopt unified definitions to reflect blockchain and smart contract advances will grow.
Enforceability of smart contracts in India
The Indian Contract Act of 1872 is the most important statute governing contracts in India. Section 10 provides that “all agreements are contracts if they have the free consent of parties ready to contract, for a lawfully approved consideration and with an object”. Any arrangement that includes an offer, acceptance, and consideration can be legally enforceable as a contract. Smart contracts appear to be permitted by definition under the Indian Contract Act, 1872. The offer, acceptance, and consideration in the form of crypto-currency constitute a smart contract, which raises the question of whether cryptocurrency is accepted as consideration under Indian law or not.
Sections 5 and 10 of the Information Technology Act 2000 allow for the legal acceptance of digital signatures and the determination that a contract is valid and enforceable by electronic methods. Furthermore, contracts digitally signed are admissible in court under Section 65B of the Indian Evidence Act 1872. As a result, the government is able to take legal action to resolve disputes between the parties.
Legal functioning of smart contracts in India
Smart contracts are essentially a platform for contracting with parties who may or may not know one other and who may be exposed to risks. Smart contracts may be enforceable under Indian law, but if caution is not exercised when dealing with the party with whom you are contracting, the repercussions of a failed transaction must be carried out on your own, as the legal system lacks a complex structure to control smart contracts.
If the contract’s consideration was not mutual, a smart contract might not be enforceable under Indian law. If the contract is unilateral, this can happen. Contracts without mutual consideration are not valid in Indian courts. However, smart contracts without mutual consideration can still be enforced through code, but a breach of such a contract would not be considered a breach in Indian courts because there would not have been a contract in the first place due to the lack of mutual consideration, which is an important factor of a contract.
The legality of smart contracts in India allows for their use, but it does not provide legal protection to the parties involved in the smart contract if they become liable or suffer damages because there is no regulatory framework in place to govern smart contracts. However, if the smart contract falls within the boundaries of contract law as defined in the statute, the law will assist to the best of its ability.
Has smart contract been in practice in India
Bajaj Electronics, a subsidiary of the Bajaj Group, is a renowned electrical equipment manufacturer. It is without a doubt one of the most important actors in the Indian economy. The company’s operations have an impact on a variety of sectors and vendors both inside and outside the organisation. The payment process for vendors is lengthy and inconvenient, owing to the fact that Bajaj deals with a variety of vendors and must guarantee that each transaction is completed correctly.
The vendor must demonstrate Bajaj Electricals’ proof of delivery, raise a supplier’s physical bill of exchange, and submit an invoice and transport documentation to Yes Bank as proof of delivery in order to obtain payment. This motivated Bajaj Electricals’ management to look for a quick and safe way to replace its manual billing system. They chose to use blockchain as a solution. The company announced in January 2019 that it would deploy a Yes Bank-developed solution for blockchain vendor financing, commonly known as supplier financing. Yes Bank isn’t the only Indian bank researching and experimenting with blockchain for supplier finance. The Mahindra Group and IBM, for example, announced in November 2016 that they are working together on a cloud-based blockchain framework that has the potential to revolutionise supply chain finance in India.
Meanwhile, the RBI’s Institute for Banking Technology Development and Research recently released a white paper on blockchain technology to help Indian banks and financial institutions prepare for their own blockchain journey.
Risks involved in smart contracts with respect to India
- Despite the fact that Indian law permits electronic contracts, Ponzi schemes, which are aided by blockchain technology, raise concerns about the viability of defending people’s interests.
- The problem is that there are no well-established legal frameworks to control crypto-transactions anywhere in the globe, whether in India or elsewhere. An electronic signature can only be received through a government-designated certifying authority, according to Section 35 of the Information Technology Act, 2000. This creates concerns because the blockchain technology generates the hash key that is to be used as an identification to authenticate the smart contract, yet there is currently no legal authority that sanctions electronic signatures.
- Section 88 A of the Indian Evidence Act, 1872, specifies that the court presumes that an electronic record brought in court is genuine, but it makes no assumptions regarding the contract’s sender. As a result, using a signature obtained through blockchain technology will only complicate the admissibility of a smart contract because the signature was obtained outside of the Information Technology Act, of 2000. This not only invalidates the blockchain technology’s encryption scheme for smart contracts, but it also prevents smart contracts from being used as evidence in court.
India and smart contracts : the future ahead
There is no doubt that the deployment and expansion of smart contracts is the next step in innovation, with the potential to save billions of dollars in administrative costs while improving the overall efficiency of the system. However, there are regulatory concerns, particularly in India, where there are no regulations governing the finer points of a smart contract. If no special restrictions are enacted, widespread deployment of the technology will necessitate changes to the Indian Evidence Act of 1872 and the Information Technology Act of 2000. As a result, while there has been some progress in terms of legislation and the business sector adopting the smart contract concept, the law remains in a grey area, and a strong commitment is necessary to develop an intricate structure to regulate the working of smart contracts in India.
Challenges with the widespread adoption of smart contracts
One of the challenges in talking about smart contracts is that the term is used to describe two quite distinct concepts:
- The first concerns smart contracts that are established and deployed without the support of a legally binding text-based contract. For example, two parties may come to an oral agreement on the business relationship they want to document and then convert that agreement into executable code. These are referred to as “code-only smart contracts”.
- The second paradigm involves using smart contracts as vehicles to carry out some provisions of a traditional text-based contract, with the text referencing the smart contract’s use to carry out specific provisions. These are what we call “ancillary smart contracts.”
How can non-technical parties negotiate, draft and adjudicate smart contracts
- Parties will need to rely on a trusted, technical expert to either record the parties’ agreement in code or check that code created by a third party is accurate, which will be a major barrier in the broad implementation of smart contracts. While some compare it to paying a lawyer to explain “the legalese” of a standard text-based contract, the comparison is inaccurate. Non-lawyers are usually able to comprehend simple short-form agreements as well as many provisions of larger agreements, particularly those containing business words. A non-programmer, on the other hand, would struggle to comprehend even the most basic smart contract, and would be substantially more reliant on an expert to explain what the contract “means.”
- To some extent, contracting parties’ inability to comprehend smart contract code will not prevent them from entering into ancillary code agreements. This is because text templates may be developed and used to define what parameters must be submitted and how those parameters will be executed for many fundamental operations. Consider a basic smart contract function that deducts a late charge from a counterparty’s wallet if a specific payment isn’t received by a certain date. The parties might be prompted to enter the amount of the expected payment, the due date, and the amount of the late fee in the text template. However, especially if the template disclaims any obligation deriving from the accuracy of the underlying code, a party may want to validate that the underlying code will fulfil the functions described in the text and that there are no additional conditions or parameters. This review will necessitate the assistance of a reputable third party with programming knowledge.
- In the event that no such templates exist and new code must be written, the parties will need to express their agreement’s intent to a programmer. It would be inefficient to just hand the programmer a copy of the legal agreement because it would need the programmer to attempt to read a legal document.
- Parties who rely on supplementary smart contracts may need to create a separate “term sheet” detailing the functionality that the smart contract should give to the programmer. The parties can additionally require formal assurances from the programmer that the code works as expected. As a result, parties may need to enter into a written agreement with the smart contract programmer for customised arrangements that do not rely on an existing template, similar to the contract that parties may enter into with a provider of services for Electronic Data Interchange (EDI) transactions today.
- Insurance companies could also create policies to protect contracting parties from the risk that smart contract code does not perform the functions specified in the text of an agreement. Although the parties should check (or have third parties review) the code, insurance can provide additional protection because the parties may overlook flaws when evaluating it. The parties would also be reassured by the fact that the insurance firm would very certainly undertake its own code audit before agreeing to insure the code.
- The courts are reluctant to enforce agreements when the consumer was not given proper notice of the conditions, and may be hesitant to enforce a smart contract if the consumer was not also given an underlying text agreement containing all of the provisions.
- Finally, courts may need a system of court-appointed experts to help them comprehend the meaning and intent of the code when the legality or performance of smart contracts is increasingly determined. When technological issues are at the heart of a disagreement, parties now commonly utilise their own experts. While both federal and state courts have the power to designate their own experts, they rarely do so.
What is the “final” agreement between the parties
Courts will evaluate the final, written document to which the parties have agreed when examining traditional text-based contracts to determine whether the parties are in compliance or breach. Courts have always stressed that the ultimate agreement represents the parties’ common intent, that is the “meeting of the minds.”
The code that is executed and the output it produces represents the only objective evidence of the terms agreed upon by the parties in the case of code-only smart contracts. Email exchanges or oral discussions between the parties about what functions the smart contract should execute would likely surrender to the definitive code lines as the determinative embodiment of the parties’ purpose in these circumstances.
In the case of ancillary smart contracts, a court would most likely view the text and code as a single undivided agreement. When the standard text agreement and the code do not match, the problem becomes more problematic. Assume that the text of an agreement stipulates that an insurance payout will be made if the temperature drops below 32 degrees, while the smart contract code says that the payment will be made if the temperature is equal to or below 32 degrees.
If the text agreement does not state whether the text or the code controls in the event of a conflict, courts will have to decide whether the code should be treated as a mutually agreed amendment to the written agreement or whether the text of the agreement should prevail—possibly on a case-by-case basis. In some ways, the approach should be similar to when the provisions of a main agreement diverge from what is contained in a schedule or exhibit attached to it. The fact that this is a conflict between text and computer code rather than two text documents should not be decisive, but courts may disagree.
Parties could employ a text-based contract in which the parameters that trigger smart contract execution are not only visible in the text but also populate the smart contract. In our example, “less than 32 degrees” would appear not just in the text, but would also be used to construct a parameter in the smart contract, reducing the likelihood of inconsistency.
Risk allocation for attacks and failures
Smart contracts bring a new risk that isn’t present in most text-based contractual relationships, such as, the danger of the contract being hacked or the code or protocol including an unexpected programming error. Given the relative security of blockchains, both ideas are very similar. For example, most ‘hacks’ linked with blockchain technology actually exploit an inadvertent coding flaw. These mistakes, like many other bugs in computer code, are not immediately apparent and are only discovered after they have been exploited. In 2017, for example, an attacker was able to drain $31 million in ether from numerous Parity multi-signature wallets. As they require more than one private key to access the wallet, multi-signature wallets give an extra layer of protection. The attacker in the Parity assault, on the other hand, was able to take advantage of a defect in the Parity system by reinitializing the smart contract and making himself the only owner of the multi-signature wallets. Parties to a smart contract must evaluate how risk and liability for accidental code errors and the exploitations that arise are shared between the parties, as well as possible with any third-party smart contract developers or insurers.
What are the best practices available for implementing smart contracts successfully
As smart contract adoption is still in its early stages, best practices for implementing such code are continuously evolving. The checklist below, on the other hand, should assist developers in creating effective smart contracts as well as enterprises planning to employ them.
- For the time being, parties entering into any form of contract should use a hybrid approach that blends text and code. Code-only smart contracts should be utilised primarily for simple transactions until further clarity on their legality and enforceability is available. Parties will continue to prefer text-based agreements so that they can read the agreed-upon terms, memorialise terms that smart contracts are unable to address, and have a document that they know will be enforced in court.
- In a text-and-code hybrid contract, the text should clearly specify the smart contract code with which it is associated, and the parties should have complete visibility into the variables passed to the smart contract, how they are defined, and the transaction events that will trigger the code’s execution.
- When using oracles for off-chain data, the parties should consider what will happen if the oracle is unable to push out the required data, gives incorrect data, or goes out of business.
- In the event of a coding error, the parties should consider risk allocation.
- In the event of a controversy, the text agreement accompanying the code should define the governing law and venue, as well as the sequence of precedence between text and code.
- Each party should certify in the text agreement that they have evaluated the smart contract code and that it reflects the provisions of the text agreement. While such a representation cannot compel a party to inspect the code, it can assist the counterparty in defending against a claim that the code was never examined. Parties can also choose to guarantee against the possibility of faults in the code. As previously stated, third-party specialists may be required to review the code.
General questions surrounding smart contracts
Smart contracts is a new concept for a large group of individuals altogether. Therefore, certain basic questions that surround the concept have been discussed hereunder, so as to make the subject matter of smart contracts similar for the readers.
What is a smart contract Blockchain
The smart contract is executed on a blockchain network, and the contract’s code is copied throughout the network’s numerous computers. This allows for more transparent and secure facilitation and execution of contractual obligations.
A blockchain is a decentralised network that consists of a growing list of records (blocks) linked by encryption. A blockchain network, unlike a traditional database, does not have a single central point. The data saved in the blockchain is shared across all of the computers that make up the network. As a result, the network is less vulnerable to potential outages or assaults.
Furthermore, a record on one computer in a blockchain cannot be changed without affecting the identical record on other computers in the network. Transactions on a blockchain are organised into blocks that are connected together in a chain. Only after the previous block has been completed is a new block formed. Each block contains a cryptographic hash of the previous block and is arranged in a linear chronological order.
Are smart contracts legal
- Smart contracts are legally enforceable if they comply with contract law of the particular nation they are being made in.
- It is necessary to keep in mind that a smart contract is not a contract in the traditional sense of a document or a series of exchanges of words, letters, emails, or other digital interactions that can serve as evidence of legally binding rights and obligations.
- Smart contracts meet all of the requirements of Section 10 of the Indian Contract Act, 1872. As a result, smart contracts are lawful and valid contracts under the Indian Contract Act, 1872.
- Smart contracts are enforceable under Indian law, but no protection can be provided because there is no regulation governing this sort of contract. There are various other challenges with respect to smart contracts, such as policy issues, jurisdictional issues, and the risk of fraud, among others.
How is traditional a contract different from a smart contract
- The time needed for formulating the contract: A standard contract can take anywhere from one to several days to prepare, draft, and formulate, depending on the quality of the legal services and the readiness of the contracting parties. When using a ready-made contract platform, this period can be shortened to a few minutes for smart contracts. Ethereum, Hyperledger Fabric, and others are examples of such platforms.
- The contract’s execution and reimbursement: In traditional contracts, the parties are required to pay the due sums on time, manually, and with additional organisational effort on their behalf. The remittance is automated in smart contracts, and it is carried out automatically when the agreed-upon conditions are met and recorded in the code.
- The total price of the procedure: Smart contracts, in theory, do not require the involvement of intermediaries or third parties, lowering their cost to nearly zero. For better or worse, this possibility remains in the distant future, and the role of attorneys in ensuring the contractor’s compliance with present legal laws is critical. Smart contracts, with or without their assistance, are not only speedier and more practical, but also a much less expensive choice for negotiating parties.
- The necessity of being physically present: Given the ever-changing dynamics of our environment, conducting remote activities without compromising their reliability is becoming increasingly important. A smart contract is completed by putting an electronic signature on it, which eliminates the necessity for the parties to be physically present, which is a drawback that regular agreements cannot avoid.
- The safety and security of data: A smart contract, unlike a standard contract, which is just a piece of paper, can provide a qualitatively new degree of security and confidentiality. Blockchain technology’s cryptographic protection provides an unparalleled level of confidentiality, particularly if the contract is recorded on a private rather than a public ledger.
- The process of archiving: Traditional contract archiving involves time, space, administration, and oversight. It happens automatically, securely, and without wasting time or natural resources with smart contracts. Smart contracts’ possible shortcomings, when compared to regular contracts, are the contract’s reduced flexibility and troublesome “readability” for those without certain backgrounds and qualifications. Fortunately, both issues may be readily resolved with the help of an experienced lawyer who is knowledgeable with the nuances of smart contracting under the present legal framework.
Can smart contracts rely on “off-chain” resources for their functioning
Many proposed use-cases for smart contracts presume that the smart contract will get data or parameters from resources that aren’t on the blockchain (so-called off-chain resources). Consider a crop insurance smart contract that is set up to transfer value to an insured party if the temperature drops below 32 degrees at any point. The temperature data will have to come from an agreed-upon source for the smart contract to work. This raises two concerns:
- To begin with, smart contracts cannot take data from off-chain resources; instead, that data must be “pushed” to the smart contract.
- Second, if the data in question is constantly changing, and the code is duplicated over numerous nodes across the network, different nodes may be receiving different data, even if it is just a few seconds apart.
Using an “oracle,” contracting parties will be able to solve this problem. Oracles are trustworthy third parties who retrieve information off-chain and push it to the blockchain at predefined intervals. The oracle in the preceding example would monitor the daily temperature, determine if a freezing event has happened, and then send that information to the smart contract.
Although oracles provide an efficient mechanism for accessing off-chain resources, the process adds another entity with whom the parties must negotiate in order to carry out a smart contract, reducing the decentralised benefits of smart contracts. It also introduces the possibility of a “failure point.” For example, an oracle could have a system flaw and be unable to send out the required information, or it could deliver incorrect data or go out of business. Before smart contracts become more widely adopted, they will need to accommodate these scenarios.
Can smart contracts be amended and terminated
- There is currently no simple way to alter a smart contract, which poses certain difficulties for contracting parties. In a classic text-based contract, for example, if the parties have mutually decided to change the terms of their commercial arrangement, or if the law changes, the parties can swiftly prepare an addendum or simply change their course of activity. Smart contracts do not currently provide this level of flexibility. Because blockchains are immutable, changing a smart contract is significantly more difficult than changing normal software code that isn’t stored on a blockchain. As a result, changing a smart contract may incur higher transaction costs than amending a text-based contract, and increases the risk that the parties’ adjustments may not be accurately reflected.
- When it comes to cancelling a smart contract, the obstacles are similar. Assume a party discovers a mistake in a contract that provides the counterparty greater rights than intended, or determines that executing its stated duties will be significantly more expensive than anticipated. In a text-based contract, a party can engage in, or threaten to engage in, so-called “efficient breach,” which entails deliberately violating a contract and paying the ensuing damages if the cost of performing is greater than the damages it would owe. Furthermore, by suspending or threatening to cease performance, a party can bring the counterparty back to the table to negotiate a mutually agreeable conclusion.
- Smart contracts do not yet provide similar self-help options. Smart contracts, which can be terminated at any time and are more readily changed, are now being developed. While this goes against the immutable and automated nature of smart contracts, it highlights the fact that smart contracts can only acquire commercial acceptability if they represent how contractual parties operate in the real world.
Do smart contracts really guarantee payment
- One of the most frequently stated advantages of smart contracts is their ability to automate payment without the need of dunning notifications or other collection costs, as well as the requirement to go to court to secure a payment decision. While this is true in simple use situations, it may not be accurate in more complicated commercial partnerships.
- In reality, parties frequently move monies within their organisations and do not “park” complete amounts due on long-term contracts in anticipation of future payment requirements. Similarly, a person who obtains a loan is unlikely to maintain the entire loan amount in a smart contract-linked wallet. Instead, the borrower will put those amounts to good use, financing the required repayments on an as-needed basis.
- If the party owed money under the smart contract fails to fund the wallet on time, a smart contract attempting to move money from that wallet in response to a trigger event may discover that the funds are unavailable.
- Adding another layer to the process, such as having the smart contract seek cash from other wallets or having the wallet “fund itself” from other sources, would not fix the problem if those wallets or sources of funds lacked the necessary payment quantities as well.
- A text-based requirement that a wallet linked to the smart contract always have a minimum amount may be used to remedy this issue, but that solution would just provide the party a better legal position if the dispute was adjudicated. It would not completely automate the smart contract’s payment function. As a result, while smart contracts will make payments significantly more efficient, they may not eliminate the need for payment disputes to be resolved.
Smart contracts are a good illustration of ‘Amara’s Law’ which states that we tend to overestimate new technology in the short run and underestimate it in the long run, as described by a Stanford University computer scientist Roy Amara. Although smart contracts need to grow before they are widely used in complex business interactions, they have the potential to change the reward and incentive structure that will determine how parties contract in the future. To that end, while considering smart contracts, it’s critical to consider more than just how old concepts and structures can be adapted to this new technology. Rather, the actual smart contract revolution will come from completely new paradigms that we have not yet envisioned.
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