This article is written by Abhishek Sood, pursuing a Certificate Course in Arbitration: Strategy, Procedure and Drafting from LawSikho.com.
Table of Contents
Introduction
Smart contracts were first proposed early in the 1990s by computer scientist, lawyer and cryptographer Nick Szabo, who coined the term, using it to refer to “a set of promises, specified in digital form, including protocol within which the parties perform on these promises”. In simple terms smart contract is a computer algorithm which automatically performs the contract thereby, allowing the performance of credible transactions without any third parties. In terms of utility, the smart contracts allow one to exchange property, money, shares or anything of value in a transparent, conflict-free way while avoiding the services of middlemen. A drink vending machine is a good example of a smart contract. Once the money is paid, it is retained by the vending machine and the drink is vended. The key characteristics of the smart contract are as under:
- Digital;
- Performance meditated by technological means; and
- Irrevocable.
An illustration on working of smart contracts
Smart Contracts are nothing but a contract written using codes which will ensure the automatic performance of the obligations when the agreed conditions are met. Let us say A takes a car on rent from a car rental company. The car rental company keeps a refundable security deposit amounting to INR 10,000/- to be returned to A if the car is returned in the same condition. The car rental company has made an app which contains various codes where the photos of the car are uploaded at the time of pick up and drop. The code is written in a way where instructions are mentioned that if the car photos at the time of pick up and drop match 100% then refund 100% if the match is >95% but less than 100% deduct 5% from the security deposit and so on. Thus, this is one way of working on smart contracts where if the agreed conditions between the parties are met it will automatically initiate the refund without the human assistance.
Usage of smart contracts in various industries
- Banking: In 2016 the Barclays Corporate Bank tested the use of smart contracts to trade in derivatives, a trading contract based on some underlying asset. In a trial, Barclays created a smart contract whose field can be pre-populated with certain values agreed by the International Swaps and Derivatives Association (ISDA).
- Verification: Employee verification and educational verification at times can take many days due to unavailability of the authorised person to confirm. However, if the records are stored in the blockchain the movement of the identification number may be a roll number or an employee code is entered as an input trigger if it matches the database in the blockchain an automatic response should be generated to the user. This will cut the delay and unnecessary human intervention.
- Insurance Claim: In case of accidents the smart contracts can play an important role to detect who was at fault by calculating the speed of the vehicle, direction, whether the driver was wearing the seat belt or not and many other factors using sensors in the vehicle. Similarly, smart contracts can be used to play an important role in the processing of claims in case of death of the life insurance policyholder. A simple electronically generated notarized certificate can ensure that the claim amount is transferred to the beneficiary without any delay.
- Medical Reports: In today’s world jack of all trade and master of none is not at all preferable. People respect and accept the advice of specialists only. A patient may be referring to a cardiologist at a different hospital, a different orthopaedic at a different hospital. Every time the patient visits the doctor he/she needs to carry its medical reports. However, if the medical reports are stored in the blockchain and can be automatically shared with the doctor for better health management.
Disputes related to smart contracts
Like a normal contract, a smart contract can also give rise to various disputes between the parties to the smart contract. The typical disputes which can arise between the parties to the smart contract are-
(i) due to technical difficulties in the smart contract application,
(ii) between the parties of a smart contract (e.g. due to the sale of defective goods),
(iii) coding errors may cause unexpected performance issues,
(iv) subsequent changes to the law or regulation may make the performance of the smart contract illegal, etc.
Arbitration as a dispute resolution mechanism
As stated above smart contracts are not 100% dispute free. Moreover, with the evolving technology, the disputes related to smart contracts will become more challenging. In such scenarios resolving a dispute by opting in for arbitration will be beneficial in many ways for the parties to the dispute. Firstly, the code or algorithm of the smart contract would be proprietary information of the parties thus, by opting in for arbitration the parties can maintain the confidentiality of its information from becoming public information, which may have commercial ramifications. Secondly, some of the disputes related to smart contracts can be complex involving technical issues, in such case, the arbitration will be a better option as the parties can choose an arbitrator with specific technical knowledge, skills and relevant experience to adjudicate the dispute.
Drafting arbitration clauses
Though the smart contracts through a computer algorithm will automatically perform some or all the parties’ obligations. However, in most of the jurisdictions across the globe to invoke the arbitration the parties need to have an arbitration clause or a separate arbitration agreement in place. Therefore, the legal terms of the contract would continue to remain in written form which could be read and understood by the parties. Thus, it becomes extremely important that the arbitration clause is drafted properly. Some of the pointers to be kept in mind while drafting the arbitration clause are as under:
- Arbitrator Appointment: The most important advantage of choosing arbitration over litigation is the ability of the parties to choose the arbitrator or arbitral tribunal of their own choice. Given the complexity which could arise in a smart contract dispute it would be beneficial and in the interest of the parties to choose an arbitrator who possesses the necessary technical knowledge about the smart contracts. For example, at present Ethereum (most popular open-source platform featuring smart contract functionality) is the second-largest cryptocurrency platform by market capitalization, behind Bitcoin. It is a decentralized open-source blockchain featuring smart contract functionality. Therefore, having a pool of arbitrators having a relevant idea about the technologies being used to create a smart contract will help the parties in resolving the disputes in a better way. Thus, parties to a smart contract should mention the qualification, professional experience, technical skills, etc. in the arbitration clause itself so that the parties have established a boundary within which the arbitrator has to fit.
- Governing Law and Arbitral Body: It is utmost important that the parties should ensure that the chosen law does not render the smart contract illegal or unenforceable or that the dispute arising is non-arbitrable. In 2017, Arizona passed the amended Arizona Electronic Transaction Act (AETA), HB 2417, which defines blockchain technology and smart contracts. Therefore, while drafting the arbitration clause and fixing the governing law it will be prudent to choose the governing law of the country which has given legitimate status to the smart contracts and in return shall ensure its enforcement. Similarly, the parties have a choice to opt-in for an ad-hoc arbitration or go for institutional arbitration. In my opinion, in case of smart contracts, the parties should go for institutional arbitration and that too for an institution which deals with matters related to technology disputes. There are many such technical arbitration institutes across the globe. In the Netherlands, SGOA (Stichting Geschillenoplossing Automatisering, or foundation for the resolution of ICT disputes) is a leading, independent non-profit centre for IT conflict management and is specialized in conflict prevention, mediation and arbitration in the field of IT. Therefore, while agreeing to the governing law and arbitral body the parties should thoroughly check about the governing law and ensure they choose the arbitral body who has the expertise to handle the dispute.
- Forum Selection: The forum of the arbitration would define the primary jurisdiction and the court seated in primary jurisdiction can invoke grounds under local laws. Either party to the dispute may like to seek certain interim orders before the arbitration tribunal is appointed or challenge the arbitral award later. In such a case, the laws of the forum chosen would govern the rights available to the parties. It is utmost important that the laws of the chosen forum should not hold the smart contracts to be illegal. For example, in the United States of America (USA) some states like Delaware, Tennessee and Arizona have passed legislation to recognize the legal effect of smart contracts. Thus, the parties can mention any forum in such states who would recognize and enforce the party’s choice of law.
- Summary Dispositions: The summary disposition in an arbitration is the dismissal or upholding of claims or defences, in favour of a party, by the arbitrators, without proceeding to a full evidentiary hearing on merits. While summary disposition may not be suitable or appropriate for many arbitrations i.e. where there are contested issues of fact that require a full factual investigation and evidentiary hearings on the merits. But at the same time having such a procedural tool in the institutional rules or the arbitrational laws of the country will expedite the process where the party’s claims or defences lack merit. Therefore, the parties while drafting the arbitration clause should consider the use of summary disposition or conversely do not want such a procedure to be used. However, in the context of smart contracts, the algorithm is going to automatically perform the contract thereby, allowing the parties to have summary disposition procedure in the arbitration clause as automation would reduce or eliminate the need for discovery, fact-finding and intent of the parties performing under the contract. However, before that, the need of the hour is to have these summary dispositions provisions being expressly incorporated under various institutional rules or arbitrational laws. In the investment arbitration the summary disposition had been part of Investment Arbitration Rules of the Singapore International Arbitration Rules (SIAC IA), International Centre for Settlement of Investment Disputes (ICSID) and China International Economic and Trade Arbitration Commission (CIETAC) rules but the need is to have similar provisions being allowed in ICC, SCC and SIAC commercial arbitrations too.
Challenges related to smart contracts using arbitration
- Enforceability of the Award: Once the award has been given by the arbitrator the other challenge would be its enforceability in case of smart contracts. Let’s say party A in whose favour the award has been given now wants to enforce it and get monetary compensation as damages from party B. How this would be given effect in the smart contracts? Will there be another code that needs to be written for such compensation to be paid from A to B? If yes, then will it be possible for the arbitration tribunal to enter the award in the blockchain and also to ensure the enforcement it will be important that both the parties need to park assets or cryptocurrency in the blockchain.
- Difficulty Identifying the Party to Sue: Let us go back to the example of the vending machine. Let us say A inserted the required currency into the vending machine to get a packet to chips. However, while he has pressed the right button due to some technical glitch or bug in the code the vending machine does not execute the command properly however, the money is retained by the machine. In such a case, if A wants to take a recourse who would be the party? Will it be the owner who has installed the machine at its premises? or the person who has manufactured the machine? or the coder who has written the code? There is for sure uncertainty about it and most probably the aggrieved party may have to read through various agreements executed between the vendor, the machine manufacturer and the coder to ascertain who is the responsible party.
- Novelty: One of the unique characteristics of the smart contracts as discussed above is that they are irrevocable. This is certainly an advantage when it comes to the performance of the obligations of the parties. However, if either of the party wants to terminate the contract before expiry of its term, what will be the procedure to be adopted? Will there be another code to be inserted in the blockchain? Or a simple mutual termination agreement would suffice the purpose.
- Abstract Legal Concepts: Another challenge which could be faced by the smart contracts would be defining the ambiguous legal concepts. At present, during the inception of COVID-19 pandemic, the clause which came to the rescue of most of the parties was “Force Majeure”. Claiming Force Majeure most of the parties postponed their obligation to make the payments to the other party. Force Majeure as a legal concept has been defined under civil code in countries like Germany. However, in countries where English law is followed it is mostly up to the parties to define the events which will trigger the right to claim Force Majeure. Till date, most of the parties subject to English law would include an act of god i.e flood, earthquake to be an event to be construed to be Force Majeure. But during COVID-19 mostly the respective ministries like the Ministry of Finance in India or trade associations like Chamber of Commerce in The Netherlands issued notifications to allow parties to suspend their obligations for the time being due to the Force Majeure event. The question is if code defining the Force Majeure does not contain the event contemplated by the parties at the time of the execution of the smart contract, will the smart contract automatically transfer the payment as smart contracts are irrevocable.
India and the Smart Contracts
In India, all contracts are governed by the Indian Contract Act, 1872. As per the Indian Contract Act, 1872 if an agreement consists of an offer, acceptance and consideration it would be a valid contract. Though the offer and acceptance could be easily captured in the smart contracts in India. The real problem was with consideration. In smart contracts, the consideration is paid in cryptocurrency. In April 2018 Reserve Bank of India issued a circular to the banks to stop providing support in cryptocurrencies. However, that circular was quashed by the Supreme Court of India in March 2020 and struck down the curb on cryptocurrency trade. Furthermore, the Information Technology Act 2000 holds electronic contracts to be enforceable. Also, the Indian Evidence Act, 1872 Section 65 B states contracts digitally signed shall be admissible in the courts. Therefore, the legal recourse can be provided to the parties to settle the disputes by making further amendments in the IT Act and the Evidence Act in the absence of specific regulations for the time being. However, If the latest reports are to be believed a high-level panel has prepared a draft law providing for a ban on all forms of private cryptocurrencies and has suggested fine up to Rs 25 crore and imprisonment of up to 10 years for anyone dealing in them. With this background, the future of smart contracts seems to be bleak at least in the many years to come.
Conclusion
The role of technology in any field is irrefutable. Therefore, the legal field is no exception as such. The use of artificial intelligence and machine learning in contract management is being appreciated and talked about a lot in the entire industry. The transition from ink signature to digital signatures changed the way the contracts are being administered by the parties. Similarly, smart contracts will change the whole dynamics of conducting the business. Therefore, to support the ever-evolving business dynamics in the era of smart contracts, we need to evolve the various dispute mechanisms in place along with proper regulations and rules. For example, we might need to enact separate legislation to provide legal validity to smart contracts in India like we have in the United States of America (USA) in states of Delaware, Tennessee and Arizona or might have to amend the existing legislatures like Information Technology Act, 2000 to create a place for smart contracts. China has also set up an internet court in Hangzhou to recognize the digital data as evidence if verified through the blockchain. Also, the arbitration institutes need to have a pool of arbitrators who are well versed with the new technologies so that they can adjudicate the disputes arising out of such smart contracts. I would like to draw an analogy out of the words of Bill Gates that “Technology is just a tool. In terms of getting the kids working together and motivating them, the teacher is the most important” therefore, the technology will keep advancing and with such advancement, we will face new kind of disputes and thus having an updated dispute mechanism to support the upcoming technologies is the most important task and I believe that the arbitration as a dispute mechanism can play a big role.
Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skill.
LawSikho has created a telegram group for exchanging legal knowledge, referrals and various opportunities. You can click on this link and join:
