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This article is written by Raghav Madan, pursuing Diploma in Law Firm Practice: Research, Drafting, Briefing and Client Management from LawSikho. The article has been edited by Kritika Sharma (Associate, LawSikho) and Ruchika Mohapatra (Associate, LawSikho).

Introduction

The digitalization of the world, followed by the global pandemic, has completely changed the way businesses work now. Almost all operational tasks are being carried out digitally. The businesses/organizations/individuals have to adapt to new ways of working in order to survive for a living. Unexpectedly, it has turned out to be a blessing in disguise for many organizations in terms of cost-saving and efficiency.

It has led to an increase in productivity, mental health, awareness, and even outreach since the digital means is accessible from any corner of the world. Followed by this efficiency, the businesses continue to incorporate this digital setup even in their legal aspects as the traditional system lacks effective enforcement. 

As per World Bank’s “Ease of Doing Business Report 2020”, India ranks 163 out of 190 countries in Enforcing Contracts. The average time taken to enforce a contract is 1445 days (approximately 4 years). However, businesses do not want to wait 4 years for a contract to be executed and look for a means to execute automatically. This automatic execution of contracts is taking shape by way of Smart Contracts.

Smart contracts work by following simple “if/when…then…” statements that are written in a coded format. It has been inspired majorly by the blockchain system where a network of computers executes an action when predetermined conditions have been met and verified.

It can be better understood through the following diagram:

In a Smart Contract, when two parties enter into a contract (Alice and Bob), it is validated through predetermined conditions. These predetermined conditions run on an oracle system responsible for connecting internal-external mechanisms and controlling what is called a “trigger system”. On performance or non-performance of the predetermined terms, an automatic trigger would take place communicating immediate action which could be the release of funds to the appropriate parties, sending notifications, or issuing a ticket (depending upon the terms of the contract) without the need of any intermediary.

Although the working of these Smart Contracts is extremely complex, on the contrary, they make the execution process a lot quicker than the traditional form of contracts.

Difference from an ordinary contract

The essential elements of a smart contract and an ordinary contract are the same (i.e, offer, acceptance, consideration, lawful object, etc.). However, unlike conventional contracts, a Smart Contract is written in a coded format that functions on an “if/when…then…” basis.

Moreover, a Smart Contract within itself can have many stipulations in order to satisfy the participants that the task will be completed satisfactorily and efficiently. This includes establishing the terms, determining how transactions and data are represented, agreeing on the “if/when…then…” rules that govern those transactions, exploring all possible exceptions, and defining an automated framework for resolving disputes. While a conventional contract may contain all such pre-determined details, a medium for immediate and automatic execution is only covered in Smart Contracts.

Benefits of smart contracts

Smart Contracts bring a plethora of advantages to businesses due to their broader perspective and coverage. They help in:

  • Increasing efficiency;
  • Avoiding lengthy judicial processes and cost;
  • Promoting innovation;
  • Standardization;
  • Trust and security;
  • Minimization of the role of intermediaries and;
  • Immediate and automatic execution.

With growing digitalization, it is gaining even more popularity and can be found in decentralized applications, payment of royalties in intellectual property rights, logistics industry, initial coin offerings, trade finance, supply chain financing, internet of things, and e-commerce industry to name a few. However, following their current position in India, the use of Smart Contracts is very sceptical, to say the least.

Reasons for not a smart move

Although, it may seem inclusion of Smart Contracts in our ecosystem would be a revolutionary change, however, considering the current progress and development, the use of Smart Contracts won’t be a smart move due to the following reasons:

Operational risks

Operational risks are associated with the working of these Smart Contracts. The main problem is that Smart Contracts work on a very rigid oracle system where the performance is programmed over “if/when…then…”  code. However, the interpretation of this term “performance” varies from contract to contract. The oracle system has a very high tendency of making a judgment error while interpreting this performance.

For example, if we use the Smart Contracts in Cab Services, the oracle system would interpret the performance of the contract when the passenger reaches a destination and then only trigger the action to transfer funds. However, supposedly followed by certain unforeseeable circumstances (say some construction work on the marked location), the driver does not drop the passenger at the exact destination but at a nearby location. While the general perception would be that there is the completion of performance on the cab service company and their driver, since the passenger was not dropped in the exact location, the oracle system will not trigger the transfer of funds.

This rigid system does not give parties the freedom to amend the terms situationally but rather makes its judgements which could be erroneous. These faults in the interpretation of Smart Contracts could easily be manipulated and misused for a sole motive.

Financial issues

Having a very deep pocket is a must for Smart Contracts. Firstly, installing and maintaining servers for the smooth functioning of these smart contracts requires an exorbitant amount of investment. Secondly, since the working of these Smart Contracts is very rigid in nature, it is almost impossible to alter their procedures. Any error in the code can be time-consuming and would again require additional expenditure. And thirdly, due to a lack of awareness around Smart Contracts, an organization would need to bear additional costs of organizing workshops, webinars, training sessions, etc. to train their employees.

A simple smart contract with no complex business logic may only cost around Rs. 5,000/- (Rupees fifty thousand), while more advanced contracts cost up to 35,000/- (Rupees thirty-five thousand) or more. It is safe to assume that large organizations with specialized knowledge would require even more investment taking the figures into lakhs. In addition, there is the cost of maintenance and regular alteration.

As a result, the central focus of Smart Contracts is to save litigation costs, which, in a broader perspective, turns out even more expensive thereby defeating the whole purpose.

Tricky balance of technical and cyber security risks

An important issue with Smart Contracts in the blockchain industry is that they are pseudonymous since they are stored on a blockchain. Indeed, transactions made on a blockchain use pseudonyms for the parties involved in the transaction. This protection is not completely anonymous, but it still does not require the parties’ legal identities.

Consequently, in case of a disagreement, smart contracts cases are almost impossible to take to the court as the only information known about the parties are their wallet address and not their identities. There are some ways to go around this issue, by using KYC requirements but that would bring a whole new set of issues relating to cybersecurity and data protection. 

Therefore, ensuring individual protection and cyber security at the same time is a very tricky balance to maintain.

Lack of discretionary power

This point is closely associated with the rigid nature of Smart Contracts. They take away the power to negotiate and discretion out of the hands of the parties. The absence of an intermediary takes out the procedure of confirmation and discussions between the parties before executing an action.

Smart contracts function on programmed logic and are immutable during the course of the execution of a transaction. However, this takes away the essence of a contract in terms of negotiation and relationship building. A contract must have a provision of modification as long as the parties to the contract mutually agree in order to ensure party autonomy.

For example, a rent agreement may impose a penalty on the tenant for non-payment of monthly rent timely. However, a landlord may waive/alter this penalty or extend the date of rent payment depending upon negotiation between the parties. However, no such discretion power is available in Smart Contracts. They work on what is programmed and will impose penalties on Tenant’s account as soon as the time expires.

This discretionary power plays a key role in building long-term relations. There needs to be certainty, predictability, and enforceability of contracts in a constructive manner which is completely missing in Smart Contracts.

Unclear legal status

Not all contracts can be executed through digital means. Certain documents like Power of Attorney, real estate, wills, etc. require a wet signature, proper registration, and stamping. Further, e-stamping is a very cumbersome process.

Due to these unclear execution procedures, Smart Contracts may not be applicable in many key sectors like real estate where there is a lack of trust in terms of execution, and building trust through quicker execution is what Smart Contract aims to achieve. 

Some also believe that this automation system takes away the judicial discretion of the Judges. Further, there is an absence of proper Smart Contract legislation and precedents in India. The IT Act in India (or any other Act for that matter) does not provide detailed working or framework as to how Smart Contracts should be regulated.

The regulatory environment will need to catch up with the speed of development in smart contracts and distributed ledgers. For example, in the US, states such as New York have already enacted regulations for digital currency businesses. Its bit license is a custom-made regulatory framework for bitcoin and digital currency businesses, which has been established by its Department of Financial Services. For contracts to be enforceable, the identity of the parties has to be confirmed to a degree that the legal system and regulators consider appropriate, and electronic signatures need to be considered valid. 

These unclear legal structures and processes degrade the level of trust and will always remain a factor in the mind of stakeholders before welcoming Smart Contracts.

Social issues

While the whole concept of Smart Contract revolves around building trust through effective execution in contracts, the fact of the matter is that there is sheer resistance to technology in India.  

Moreover, followed by a lack of awareness and understanding of Smart Contracts, there is a tendency of employees to commit unintended errors. Companies can suffer merely because of an employee’s lack of understanding of Smart Contracts. The presence of this issue is clearly visible in the Cab Service example.

Followed by a lack of awareness and understanding, there is a dearth of smart contract and blockchain talent and capabilities within financial services firms. For example, companies may need to recruit “coder lawyers” – a very rare combination of skills that combines a solid understanding of both law and computer programming. 

Organizations need to put in place skills development programs for their existing resources, and some startups have started to provide training support on their platforms, such as Brian Crain, Head of Business Development at Eris Industries, outlines. “Acquiring knowledge and skills is crucial at this stage. We designed training for developers to understand blockchain, smart contracts and how to build enterprise-grade smart contract applications,” he says.

While some concerns are genuine, others tilt towards the negative mindset towards the technology thereby leading to a lack of acceptability of these contracts in the social domain.

Way forward

Having discussed the limitations of effectively implementing Smart Contracts in India, here is how these hurdles could be avoided:

Critically evaluating the needs

The hype around smart contract technology should not cloud the thought processes behind whether smart contracts are needed in the first place. Gideon Greenspan, CEO and Founder of MultiChain, a private blockchain platform, highlights the importance of use case selection and states “Use-cases must be carefully evaluated as many proposed blockchain use-cases can be implemented efficiently via traditional or distributed databases as well”.

“We see clear applications for banks and other financial institutions. Respectively, these are small trading circles, provenance for trade finance, bilateral contract notarization, and the aggregation of AML/KYC data.” 

In a business model, it is important to implement Smart Contracts where they are properly structured, well defined and, where business partners can provide identity so that the success of transactions can be easily measured.

Creation of a hybrid model

As mentioned before, the rigid framework of Smart Contracts takes out the discretionary and negotiation power of the parties. However, this can be solved through a hybrid model by way of a confirmation or some sort of consent from the relevant parties before an automated action. This could be similar to permissions that applications in our smartphones undertake before accessing our camera, location, microphone, etc.

Although the execution would not take place in real-time it will ensure party autonomy and the contract can be amended as per the terms as and when mutually agreed. Parties should not be compelled to accept automated decisions without any discretion.

However, it is important to ensure that the role of intermediary does not defeat the purpose of Smart Contracts. The role of intermediaries shall restrict to taking a final call or what parties agree. The idea is to avoid Smart Contracts from taking excessive control which is against the discretion of parties.

A possible solution can be through programming the oracle system on a “may” and “should” coded system. During the execution of the trigger mechanism, “may” would ask for confirmation, and “should” would automatically trigger the execution. Again, the parties must agree beforehand the conditions would fall under each category to avoid ambiguity.

Strategic alliance

It is imperative that businesses can move beyond challenges related to talent and smart contract model innovation by forging strategic partnerships with experts in the space. They need to make an informed decision on partnering with the smart contract startup ecosystem. This can be prominently used in the financial industry where banks and insurers can develop an understanding and strategically align the transaction structure that helps both the parties constructively and strategically.

Further, the government can align its objectives with private entities and collaborate to make the laid-back administrative system more efficient. This would also build trust in the eyes of the community and attract more investors.

Creating a talent pool

Creating a talent pool will solve the problem of lack of awareness about the subject matter. The first step businesses need to undertake is to form an internal team focused to understand the technology, its impact, and areas of usage. Employees can also be sent for external conferences and industry working groups or internal knowledge sessions and Hackathons to gain and exchange relevant knowledge. In foreign countries, some firms even include Smart Contracts and the blockchain industry as part of their strategic investment.

Conclusion

Smart Contracts today can be compared to what the Internet was in the early 1990s. While we have witnessed how the ‘Internet of Information’ has changed our society over the past two decades, we are now entering a phase where Smart Contracts and the blockchain industry may do the same by ushering in a new paradigm comprising ‘Internet of Trust’ and ‘Internet of Efficiency’.

The presence of Smart Contracts can be seen today in maintaining clocks, escrow, ledgers, sensors, death certificates, land registries, maintaining registers, and more so through distributed technologies. Although followed by a lack of legal, structural, and social backing, businesses would need to adapt the Smart Contracts by carefully evaluating the needs, amending the prevalent structural models, strategic alliance for mutual benefits, and creating a talent pool.

However, given the current state of affairs, it is safe to say that the use of Smart Contracts won’t be a smart move.

References


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