This article has been written by Shambhavi, pursuing a Diploma Programme in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho.
Table of Contents
Introduction
Nick Szabo, a computer scientist and cryptographer coined the term “smart contract” in 1994. According to him:
“New institutions, and new ways to formalize the relationships and 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 a digital form including protocols within which the parties perform on these promises.”
Brief history about the origin of smart contract
Smart contracts are basically new age software-based contracts where the software automates the business processes. As IT is entering all fields of our daily life, smart contracts have become an effective tool for corporate governance with fewer middlemen supervision and costs. Although these types of contracts are still in their early stages of development and adoption, they can very well be incorporated into our legal system with the help of technology because they can have clauses similar to our regular contracts. Smart contracts find their origin in the Ricardian Contracts, a concept published in 1996 by Griag and Howland as part of their work on Ricardo payment system to transfer assets.
In this article, we will briefly discuss what smart contracts are, how it works and how arbitration clauses can be included in a smart contract.
What is a smart contract?
Smart contracts are basically software-based contracts that are stored on the blockchain. Storing such contracts on blockchain makes the contract more secure because a blockchain is essentially a digital ledger of transactions that is duplicated and distributed across the entire network of computer systems, thus, making it extremely difficult for the system to be corrupted as it requires enormous computing power to override the entire system. These contracts are also processed by the blockchain which means that the contract can be executed without third party interference and at the same time provide various benefits such as security, permanence and immutability that a blockchain offers.
Some of the key properties of smart contracts are autonomy, decentralization, auto-sufficiency and irrevocability. Smart contracts are usually triggered by an act that can be termed as the initiator of the transaction according to the terms of the contract and after such act triggers the contract, the initiator does not have to participate as the codes of the contract itself will initiate the other transactions according to the contract. It will not require any help or interruption.
Smart contacts are presently best suited for two types of common transactions, normally present in most of the contracts, they are:
1) Ensuring the payment of funds upon certain triggering events.
2) Imposing financial penalties if certain objectives or conditions are satisfied.
These processes, if executed through a smart contract, will eliminate the need for a trusted escrow holder or even the judicial system which in turn will reduce the enforcement costs of the contracting processes.
Uses of a smart contract
In addition to the above mentioned common transactions, smart contract, if utilised properly, can be applied to a number of cases, such as:
Insurance
Lack of automation in processing insurance claims can lead to months of delay to process claims and it is problematic for the customers. Smart contracts can solve this problem by automatically triggering a claim when certain events occur and this can save time, costs and at the same time, make the entire process more efficient.
Supply Chain management
Keeping a check on the flow of goods can be a difficult task for any company. Smart contracts here also can save time and money and make the process more efficient by recording ownership rights as the items move through the supply chain, confirming who is responsible for the product at a given time.
Mortgages
Smart contracts can automate mortgage contracts by automatically connecting the parties and providing for a frictionless process. Such smart contracts can also automatically process payments and release liens from land records when the loan is paid.
There is another kind of smart contract called the stellar smart contracts that can be used to build more sophisticated smart contracts. A stellar smart contract is expressed as the composition of transactions that are connected and executed using various constraints such as:
- What keys are needed to authorize a certain operation?
- Batching- What operation must occur together or fail?
- Sequence- In what order should a series of transactions be processed?
- Time bounds- When can a transaction be processed?
Thus, smart contracts not only cover some simple transactions but can also be used for more sophisticated contracts.
In the light of the above-mentioned facts, it is quite clear that smart contracts can be effectively used in our day to day contract work. However, there are also some drawbacks to the use of such contracts.
Drawbacks of smart contract
Smart contracts provide huge potential benefits in terms of reduction in transaction costs, security, etc. However, disputes can still arise and the service of lawyers will still be needed.
Also, the intersection of contract laws and codes create new areas of disputes altogether. Coding errors can cause unexpected issues and there can be discrepancies between coding and natural language.
The irrevocability of smart contracts means that if the parties to the contract want to terminate the contract on grounds of misrepresentation, it will become very difficult to stop the enforcement of such contracts. Such problems can also arise when there are changes in law or if there are some sanctions on some things that make the contract itself illegal.
In all the above situations, smart contracts can give rise to a number of dispute resolution challenges that require a robust arbitration clause for finding a solution and a team of lawyers.
Arbitration clause in a smart contract
In the face of various issues, arbitration is likely the key to resolve the various disputes that might emerge. However, including an arbitration clause in a smart contract will make the evolution of arbitral bodies, arbitrational laws and procedures an absolute necessity.
There should be many other changes made such as:
Appointment of an arbitrator
Careful consideration should be given to the appointment of the arbitrator and the arbitrator should have knowledge regarding technology because in the case of smart contracts, using the traditional model of arbitration won’t work.
Forum selection
Forum selection plays an important role because of the local laws that might be applied. If the contract is not entirely domestic in scope, the arbitration may be subject to the UN convention and enforcement of foreign arbitral awards.
Confidentiality
If a dispute is likely to arise regarding the source code and other proprietary hardware or software, there must be a confidential arbitration clause as these things can have huge monetary and commercial ramifications.
The parties who have entered into a smart contract may have the option to agree to refer disputes below a certain threshold to a central blockchain administrator with the power to determine disputes and remedial transactions into the blockchain as necessary.
Also, parties should ensure that they can establish consent to the arbitration agreement as the issue of consent can arise when a smart contract is entered into by a computer.
Enforceability of smart contracts
The Uniform Electronic Transaction Act was implemented in about 47 states in the US in the year 1999 which made electronic contracts valid and the way of using electronic signatures also became a valid way of providing contractual consent.
In the European Union, legislation has been passed which regulates the legality of all commercial contracts in the EU and the UK is also keen on integrating smart contracts into their legislation.
In India, a smart contract very well fits the definition of a contract under the Indian contract law and Section 10 of the Indian Information Technology Act, 2000 legally accepts digital signatures.
However, there is still no proper legislation in India that makes a smart contract valid or provides regulations for such types of contracts. The lack of such legislation means no protection of law to the parties who enter into such contracts.
Conclusion
The concept of smart contracts is a relatively new concept and regulation and enforceability of such contracts require legislation based on research. The presence of an effective and improvised system of enforcement for such contracts is also necessary and at the same time, the option of dispute resolution through arbitration should be available to the parties of the contract.
The full development of the concept of smart contracts will require a coordinated contribution of the legal system as well as the IT industry. Smart contracts are, without proof, an effective way of enforcing some regular transaction clauses without any third party interference and reducing the burden of the courts.
In some advanced countries like the US, such contracts have been easily enforced because of good technological infrastructure and availability of trained personnel. India is still lacking in both these aspects and we can only slowly incorporate such developments, however, it does not mean that it is not possible in our country. We must put in concentrated efforts to make it possible.
References
- Tips for drafting arbitration clauses: https://www.lexology.com/library/detail.aspx?g=f29fe383-b419-46c3-9cbc-78b457a937
- Why are Smart contracts so important: https://site.ieee.org/sb-ritb/why-are-smart-contracts-so-important/
- An introduction to Smart contracts and there potential and inherent limitation: https://corpgov.law.harvard.edu/2018/05/26/an-introduction-to-smart-contracts-and-their-pot ential-and-inherent-limitations/
- Role of Smart Contracts in blockchain: https://www.infosys.com/insights/digital-future/smart-contracts.html
- Uses of Smart Contract: https://corporatefinanceinstitute.com/resources/knowledge/deals/smart-contracts
- Enforceability of Smart Contracts in India: https://www.mondaq.com/india/contracts-and-commercial-law/874892/the-enforceabilit y-of-smart-contracts-in-india
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