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This article is written by Shruti Chaurasia, pursuing Diploma in Advanced Contract Drafting, Negotiation, and Dispute Resolution from LawSikho.

Introduction

A “smart contract” is a program that is stored on the blockchain and runs when predetermined conditions are met. They are usually used to automate the implementation of the agreement so that all participants can determine the result immediately, without the involvement of an intermediary or wasting time. They can also automate the workflow and trigger the next action when a condition is met. Smart contracts are a key element of many applications and platforms created using blockchain or distributed ledger technology. 

This article will describe the background and functions of smart contracts, their applicability, and highlight certain legal and practical considerations that need to be addressed before they are widely used in business environments.

What is a smart contract?

A “smart contract” runs on the Ethereum blockchain. A collection of code (functions) and data (state) resides at a specific address on the Ethereum blockchain.

Smart contracts are basically types of Ethereum accounts. They have a balance and can forward transactions over the network. They are not managed by a user, rather they are deployed to the network and run as programmed. User accounts interact with a smart contract after submitting transactions that carry out a function defined on the smart contract. This type of contract defines rules, like any regular contract, and automatically enforces them via the code.

It is a decentralized application that carries out business logic in response to events. The performance of a Smart contract can result in the exchange of money, delivery of services, unlocking of content protected by digital rights management, or other types of data manipulation such as changing the name on a land title. Smart contracts enforce privacy protection by facilitating the scrupulous release of privacy-protected data to meet specific requests. The programs underpinning smart contracts are developed, distributed, managed, and updated in a diversity of structures. They can be stored either as a part of the blockchain or either as other distributed ledger technology, and combined into several payment mechanisms and digital exchanges including bitcoin and other cryptocurrencies. Smart contracts are not legally binding contracts. Its principal function is to programmatically perform business logic that executes various tasks, processes, or transactions that are programmed into them to respond to a given set of conditions. To link the execution to a legally binding contract, parties shall unanimously undertake legal steps

Historical background of smart contracts

Computer scientist and cryptographer Nick Szabo first introduced the term “smart contract” some 20 years ago as a graduate student at the University of Washington. According to him:

“New institutions, and new ways to formalize the relationships that make up these institutions, are now made possible by the digital revolution. I call these new contracts “smart,” because they are far more functional than their inanimate paper-based ancestors. No use of artificial intelligence is implied. A smart contract is a set of promises, specified in digital form, including protocols within which the parties perform on these promises.”

Compared to paper contracts, smart contracts are smarter as they can automatically execute certain pre-programmed steps, nevertheless, it should not be perceived as an intelligent tool that can parse a contract’s more subjective specifications. Szabo has offered a classic example of a smart contract, which is that of a vending machine. As a purchaser satisfies the conditions of the “contract”, the machine automatically acknowledges the terms of the unwritten agreement and delivers the snack.

Today’s smart contracts determine their origin in Ricardian Contracts. Ricardian Contract is a concept published by Ian Grigg and Gary Howland as part of their work on the Ricardo payment system to transfer assets in 1996. Grigg observed Ricardian Contracts are a bridge connecting text contracts and code that had the following parameters: a single document that is:

  1. Offered by an issuer to holders, 
  2. For a valuable right held by holders, and managed by the issuer,
  3. Easily readable by people (like a contract on paper), 
  4. Readable by programs (perusable like a database), 
  5. Digitally signed, 
  6. Carries the keys and server information, and 
  7. Allied with a unique and secure identifier.

How do smart contracts function?

Smart contracts describe computer code that automatically performs all or parts of an agreement. It is stored on a blockchain-based platform. The code can either be the sole manifestation of the agreement between the parties or it might complement a traditional text-based contract and execute certain provisions. The code is replicated across various nodes of a blockchain and, accordingly, profits from the security, permanence, and immutability that a blockchain offers. That replication further suggests that as each new block is added to the blockchain, as a result, the code is also executed. By initiating a transaction, if the parties indicate that certain parameters have been met then the code will execute the step triggered by those parameters. If no such transaction has been instated, the code will not take any steps.

Now, the input parameters and the execution steps shall be precise and accurate. The real duties that smart contracts perform are fairly rudimentary, such as automatically moving an amount of cryptocurrency from one party’s wallet to another when certain criteria are satisfied. As the adoption of blockchain spreads, and as more assets are tokenized or go “on-chain,” smart contracts become more complex and competent in managing complicated transactions. Developers are already stringing together various transaction steps to build more complex smart contracts. Nevertheless, we are many years away from code being able to determine more subjective legal criteria, like whether a party satisfied a commercially reasonable effort standard or whether an indemnification clause should be triggered and the indemnity paid. Currently, smart contracts are quite suited to execute automatically two types of transactions found in several contracts that are: 

  1. Ensuring the payment of funds upon certain triggering events and,
  2. Imposing financial penalties if certain objective conditions are not satisfied.

In both cases, human interference is not needed once the smart contract has been deployed and is operational, that is through a trusted escrow holder and also the judicial system.  It thereby reduces the execution and enforcement costs of the contracting process.

Benefits of smart contracts

Following are the several potential business advantages of using smart contracts:

  • Speed, efficiency, and accuracy

The contract is executed immediately upon the fulfillment of the condition. There is neither a paperwork process nor any time is spent reconciling the errors as smart contracts are digital and automatic, which often result from manually filling in documents. 

  • Trust and transparency

There is no third party involved in a smart contract, also encrypted records of transactions are shared over to participants, therefore, the question of whether the information has been altered for personal benefit does not arise.

  • Security

Blockchain transaction records are encrypted, which makes it extremely difficult to hack them. Further, as each record is connected to the previous and subsequent records on a distributed ledger, hackers would have to alter the whole chain to change a single record.

  • Savings

Smart contracts eliminate the need for agents to handle transactions and, in addition, their associated time delays, and fees.

Are smart contracts enforceable?

Smart contracts basically provide a platform for signing contracts with parties who may or may not know each other and who may also bear risks. According to Indian law, smart contracts can be enforced, but if you are not cautious with the party with whom you sign, the consequences of the transaction failure should be borne by yourself, because the legal system does not have a complex system for monitoring smart contracts. The situation where the contract may not be enforceable may be that the consideration of the contract is not mutual.

This can happen if the contract is unilateral in nature. Indian courts do not allow contracts without mutual consideration to be valid, but smart contracts that do not require mutual consideration can still be executed by code, but breach of such contracts will not be regarded as a breach of contract in Indian courts, because in the eyes, due to lack of mutual consideration, The court will not sign the contract in the first place, which is an important factor in the contract. 

The legality of smart contracts in India allows the use of smart contracts, but it does not provide legal protection for parties involved in smart contracts to assume responsibility or incur damages, because there is no regulatory framework for monitoring smart contracts, if smart contracts are defined in the contract law Within the scope of the law, the law will help to the greatest extent possible.

How can non-technical parties negotiate, draft and adjudicate smart contracts?

A key challenge in the widespread adoption of smart contracts is that all parties need to rely on trusted technical experts to obtain the parties’ agreement in the code or confirm that the code written by a third party is accurate. Although some people compare this to hiring a lawyer to explain the “legal jargon” of traditional text-based contracts, this kind of comparison is wrong. Non-lawyers can usually understand short, simple agreements, and many of the terms of longer agreements, especially those that stipulate business terms. However, even with the most basic smart contracts, non-programmers will be completely at a loss, so it is much more responsive to explain to experts what the contract “says”. 

To a certain extent, the inability of contract parties to understand the smart contract code will not become an obstacle to signing the stub code agreement. This is because, for many basic functions, text templates can be created and used to indicate which parameters should be entered and how to execute them. For example, suppose there is a simple smart contract function, if the defined payment is not received before a certain date, it will withdraw the late fee from the counterparty’s wallet. The text template may require the parties to enter the expected payment amount, due date, and the number of late fees. However, one party may want to confirm that the code-behind actually performs the functions specified in the text, and there are no additional conditions or parameters, especially when the template is not responsible for the accuracy of the code-behind. This review will require a trusted third party with programming experience. In the event that such a template does not exist and new code needs to be developed, each party should communicate the intention of its agreement to the developer. Simply giving that programmer a copy of the legal agreement is inefficient because it requires the programmer to try to decrypt a legal document. Therefore, parties that rely on auxiliary smart contracts may need to write a separate “term list” for the functions to be performed by the smart contract, which can be provided to programmers. 

The parties may also expect the programmer to provide a written statement that the code meets expectations. The end result is that for customized arrangements that are not based on existing templates, parties may need to sign a written agreement with the smart contract programmer, similar to the contract that each party may sign with an electronic data service provider. Today’s Exchange Transaction (EDI). Insurance companies can also formulate policies to protect contracting parties from the risk of smart contract code not performing the functions specified in the agreement text. Although both parties also want to review (or have a third party review) the code, insurance can provide additional protection because both parties may miss errors when reviewing the code. The fact that the insurance company may conduct its own code audit before agreeing to insure the code will also be gratifying to both parties. Pure code smart contracts for business-to-consumer transactions may bring a series of additional problems that need to be solved. 

The court is cautious about the execution of the agreement, in which the consumer has not received sufficient notice of the terms of the agreement, and when the consumer has not received the basic text agreement containing the terms, he may hesitate to execute the smart contract. Finally, as the validity or performance of smart contracts gets more and more rulings, the court may need a system of experts appointed by the court to help them decipher the meaning and intent of the code. Today, when technical issues are at the core of disputes, the parties usually use their own experts. Although the federal courts and many state courts have the power to appoint their own experts, they rarely exercise this power. This approach may need to be changed if the number of standard contract disputes focusing on the interpretation of smart contract codes increases.

Amending and terminating smart contracts

At present, there is no simple way to modify smart contracts, which brings up certain challenges for the contracting parties. For example, in a traditional text-based contract, if both parties have mutually agreed to change the parameters of their commercial agreement, or if the law changes, both parties can quickly draft amendments to deal with the change, or simply change their behavior. Smart contracts currently do not provide this flexibility. In fact, because the blockchain is immutable, modifying smart contracts is much more complicated than modifying standard software code that does not exist on the blockchain. The result is that modifying smart contracts will result in higher transaction costs than modifying text-based contracts and increase the margin of error that parties cannot accurately reflect the modifications they want to make.

Suppose one party discovers that an error in the agreement gives the other party more rights than expected, or concludes that fulfilling its obligations will be much more expensive than expected. In a text-based contract, a party may participate in or threaten the so-called “effective breach of contract”, that is, if it is determined that the performance cost is higher than the loss it will bear, it will deliberately breach the contract and pay for the resulting loss. In addition, by stopping performance or threatening to take this step, one party can bring the other party back to the negotiating table to negotiate an amicable solution. Smart contracts have not yet provided a similar self-service solution; a project is currently underway to create smart contracts that can be terminated at any time and are easier to modify. Although this is somewhat contrary to the immutability and automated nature of smart contracts, it reflects the fact that smart contracts will only be commercially recognized when they reflect the commercial reality of the parties’ behavior.

Conclusion

There is no doubt that the implementation and growth of smart contracts is the next step in innovation, which can directly lead to the minimization of billions of indirect costs while making the entire system more efficient. There are no finer details about smart contracts. If no specific regulations are made, the widespread adoption of this technology will require the government to amend the Indian Evidence Act of 1872 and the IT Act. Therefore, despite the progress of legislation, as well as the business sector. In the concept of smart contracts, the law continues to play a role in the gray area, and it takes a huge effort to establish a complex framework to regulate the operation of smart contracts in India. 

Today, smart contracts are a typical example of “Amara’s Law.” Stanford University computer scientist Roy Amara elaborated on this concept. We tend to overestimate new technologies in the short term and underestimate it in the long term. Although smart contracts need to evolve before they are widely used for production purposes in complex business relationships, they have the effect of radically changing the reward and incentive structure that will shape the way parties will contract in the future. For this reason, when considering smart contracts, it is important not to simply consider how to apply existing concepts and structures to this new technology. On the contrary, the real smart contract revolution will come from a new paradigm that we have not yet imagined.

References


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