This article is written by Anjali Singh, pursuing a Certificate Course In Technology Contracts from LawSikho.

Future of contracts

Contracts are described as a framework for business operations. A good commercial contract evolves itself in three stages: (i) preparation, (ii) drafting of clauses and, (iii) implementation and management. While a business relationship between parties comes into effect with the signing of a contract, the object of entering into a contract is fulfilled only if the implementation of the contract is meticulously planned and effectively managed.

Today, the focus is on the results of contracting as opposed to the process of contracting. It takes an enormous amount of resources for businesses to design, finalize and manage contracts. Inefficient contract management can cause Companies to lose a major chunk of a given deal owing to the challenges encountered. 

By leveraging technology, businesses can overcome many challenges related to contracting. As contracts are increasingly being recognised as ‘critical business assets’ globally, it is extremely important for the organizations to have efficient contract management in the near future. New technology in the form of ‘smart contracts’ is changing the way legal matters are drafted and executed.  

What are smart contracts?

‘Smart contract’ is a computer code which is stored on a blockchain, that automatically executes agreement or part of it when predetermined terms and conditions are met. At the most basic level, they are self-executing transactions written in computer code and performed in an automated way. 

According to Nick Szabo, a computer scientist and cryptographer who first introduced the term ‘smart contract’ in 1994, “Smart contract is a set of promises, specified in digital form, including protocols, within which the parties perform on these promises”. These contracts are termed ‘smart’ because they are far more functional and autonomous than their inanimate traditional contracts. 

The classic example of a smart contract is a vending machine. As soon as the purchaser satisfies the conditions of the contract i.e. inserts money into the machine, the machine automatically honours the terms of the agreement and delivers the food item, etc. Thus the major attribute of smart contracts which sets them apart is their ability to automatically and relentlessly execute transactions without any human intervention. 

Smart contracts fulfil all the criteria laid down under section 10 of the Indian Contract Act, 1872. India is not lacking behind in recognizing the potential of Blockchain technology. Various government institutions like MeitY and TRAI have started to include Blockchain as a part of their research and development programs. 

How are they formed?

Smart contracts operate using blockchain technology. The contracting parties mutually agree with each other using a Code which is digitally set in the computer. These codes consist of all the mutually agreed terms and conditions of the parties and also contains information that executes the transactions and ensures that these transactions are tracked and are irreversible. It is only upon fulfilment of these terms and conditions that the contract gets executed.  

Blockchain is a shared, distributed ledger on which each transaction is digitally recorded and linked together by way of ‘nodes’. These transactions are recorded for perpetuity thereby providing the entire history or provenance of an asset. A transaction is added to the blockchain only after it has been validated using a consensus protocol, which ensures it is the only version of the truth. Each record is also encrypted to provide an extra layer of security. It is impossible for a user to unilaterally delete, amend or modify a particular transaction existing on the Blockchain without any other user noticing the same. 

By initiating a transaction, if the parties indicate that certain criteria have been satisfied, the code will automatically execute the step triggered by those criteria.  The code will not take any steps in the event of no such transaction having been initiated. Smart contracts interpret, verify and automatically execute any transaction in tangent with the terms. In effect, the actual tasks that smart contracts perform are mostly rudimentary, such as automatically moving an amount of cryptocurrency from buyer’s wallet to seller’s when certain parameters are met. 

The codes used in the smart contracts are written in one of the programming languages which suits such programs.

What are the advantages of smart contracts?

Smart contracts have various advantages primarily being the dispensing away with the need to involve an intermediary for the purpose of drafting a contract and its enforcement. Smart contracts execute themselves in the event of all the terms and conditions being fulfilled leaving no scope for a middleman to intervene and thus reduces the transaction & implementation costs and helps maintain autonomy. 

Smart contracts eliminate the obstacles which hinder business growth. While the parties to traditional contracts intentionally retain ambiguous terms in the contract to leave room for the benefit of interpretation, smart contracts record all the terms and conditions explicitly and do not accommodate such vagaries. This helps in avoiding claims, disputes, long drawn legal battles, exorbitant legal expenses and project delays.

Recording of transactions on a ledger which is publically available in case of smart contracts, provides for greater transparency and accountability and is difficult to breach.

The outcome-based approach on which smart contracts are modelled, also take human emotions, inherent bias and distrust out of the equation.

Further, smart contracts also address the inefficiencies of traditional contract management leading to several complications like missed deadlines and renewal dates, compliance and regulatory violations, difficulty in finding and retrieving contracts and possibility of errors usually faced in paper-based processing of contracts.

As smart contracts run on software codes, speed of executing transactions is much quicker. In brief, Smart Contracts are embossed with a myriad of features like transparency, security, cost effectiveness and autonomy, without zero possibilities of bias, manipulation, and error. 

Where do smart contracts work best?

Considering the advantages, smart contracts are relevant in various fields of applications. At present they are suited best to automatically execute the following two types of transactions found in the contracts: (i) Payment of due amount upon triggering of certain events and (ii) imposing penalty if certain objective conditions are not satisfied. Considering this, it can reasonably be concluded that Smart contracts are potentially one of the best tools in financial and insurance sectors, construction, supply chain, energy resources, real estate, healthcare, banking, etc. In all these cases, human intervention be it through judicial intervention or through a trusted escrow holder or by any other means, is not required once the smart contract has been deployed and it becomes operational, thereby reducing the overall enforcement costs of the contracting process.

Smart contracts could also prove to be useful in eliminating the so-called ‘procure-to-pay gaps’. When the seller sends the product to the buyer at his warehouse, a smart contract could immediately trigger requests for the required approvals and once the requisite approvals are obtained, it would immediately transfer funds from the buyer to the seller. On the enforcement side, a smart contract could be programmed in such a way that if the payment due is not received, it will immediately shut off access to an internet-connected device till the due payment with penalty is paid. For example, access to certain content might automatically be disabled if payment is not received.

Conclusion

The effectiveness of the contracting process is gauged by its success in successfully delivering the outcomes as envisaged at the outset and avoiding disputes and disagreements. The advent of blockchain has made smart contracts one of the most sought-after technologies as they are effective in addressing these issues. Smart contracts have the benefit of increasing confidence and certainty and enhancing business-to-business transaction performance. This has given rise to many smart contract applications in areas ranging from energy resources and voting to financial services, life sciences and healthcare. As the smart contracts are still in their infancy, stakeholders who interact with them such as users, developers and the organisations may face many challenges in utilizing them.

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