A smart contract can be said to be a self-executing and autonomous program which effectuates the terms of a contract between two or more parties and which is embedded on a distributed ledger (“DLT”). DLT is a decentralized database that is managed by various participants who record transactions using consensus protocols and a block chain is a type of DLT which uses cryptography to record transactions. By design, a DLT enables greater transparency which in turn makes fraud and manipulation difficult.
While online contracts processed through automated systems are common (take for example online trading in shares) what distinguishes smart contracts is the use of DLT to record transactions and the ability to autonomously execute transactions based on various inputs including online sources. An ATM is an apt albeit a rudimentary example of the characteristics of a smart contract. If the card holder fulfils certain actions (such as entering the correct PIN) and certain rules are fulfilled (the customer should have sufficient balance), money is dispensed to the card holder.
As stated earlier, a smart contract does not just contain the terms of the contract but also executes rights and actions arising out of the contract upon the occurrence (or non-occurrence) of an event. For example, an escrow can be released without any human intervention if the precedent conditions have been fulfilled. A smart contract is also irrevocable as the outcomes for which the smart contract has coded to perform, cannot be typically stopped, once the conditions have been met. As such, it can be said that a smart contract can facilitate, validate as well as enforce a contract.
Most businesses (such as supply chain, education, real estate, automobile etc.) can benefit greatly from the use of smart contracts. The unique features of a DLT i.e. immutability and decentralization negates the need of intermediaries. Efficiencies which arise due to automated execution would result in various benefits including cost savings, enhanced governance and transparency. And since DLTs ensure immutable and accurate records, organizations, by using smart contracts, can also overcome issues such as fraud and opacity of data.
One common misconception is that a smart contract has to be completely coded i.e. there is should no underlying text based contract. However this may not be practical as certain contract terms may not be amenable for coding. Smart contracts can also be leveraged to effectuate certain provisions of a traditional text-based contract, wherein the text based contract provides for the use of ancillary smart contracts for specific provisions. For example, a text based flight insurance contract apart from providing for insurance in the event of loss of life, may also contain a provision for payout in case of flight delays. Specific terms such as, what constitutes a delay, eligibility criteria and method for calculation of the payout and the initiation (triggered based on inputs from online flight tracking sites) and the execution (automatic payout) can be handled through an ancillary smart contract. Further, the prospective modification of terms of the smart contract can be effected easily and seamlessly.
While the information recorded on a DLT is generally accessible to all participants, confidentiality can be ensured by restricting access to confidential data to specific participants only.
The Indian Contract Act of 1872 (“Contract Act”), is the predominant statue which regulates contacts. Section 10 of the Contract Act articulates the essentials of a valid contract which include lawful consideration, lawful object, free consent & competency to contract. As a smart contract can be designed to accommodate the aforesaid stipulations, it can be said that, prima facie, a smart contract would be allowed under the provisions of the Contract Act.
However, there are certain ambiguities with respect to the validity and admissibility of smart contracts in the current legal framework. Smart contracts are generally signed and authenticated using public and private keys generated using cryptography. However as per Section 36 of the Information Technology Act, 2000 (“IT Act”), such keys (referred to as digital signatures) can only be issued by a Certifying Authority. Since the DLT may not recognize or accommodate keys issued by an external actor i.e. the Certifying Authority, it may lead to a situation wherein the admissibility of a smart contract before a court of law may be questioned. At the same time, the IT Act has provisions which allow for the recognition of other authentication techniques (referred to as electronic signatures) under Section 3A of the IT Act. In essence, the method of authentication of a smart contract has to comply with the provisions of the IT Act.
At the same time, disruptive technologies have thrown up unique issues without any comparable legal precedence. As such, the intersection of law and the technology which underpins smart contracts would result in new areas of potential dispute which are foreseeable or which would be realized as adaption of smart contracts becomes main stream. Illustrative examples of such disputes may include:
Apart from the above examples, thematic issues relating to jurisdiction, data privacy, data protection and confidentiality would also have to be addressed. For instance, considering that data in a DLT is decentralized, it may be difficult to ensure that “reasonable security practices and procedures” as prescribed under Section 43A of the IT Act, are being adhered to. That being said, technology is sufficiently nimble and solutions and products to address such issues exist or are being developed. On the same note, it is anticipated that the legal ecosystem will be sufficiently dexterous to address emerging legal issues.
Despite the hype, smart contracts are not mainstream yet. Smart contracts have been adopted by specific industries (such as financial services) and that too where the contract terms are relatively easy to understand and code. Translating complex contracts into code is not easy particularly when the terms include an element of subjectivity and thus cannot be easily translated in code. Further, interoperability across different technologies and platforms is an issue. For example, smart contracts to effectuate payment to vendors may not be feasible if the external actor’s such as bankers do not support interoperability with the DLT. As such, the use cases where smart contracts may be practically implemented are currently limited.
Roy Amara, a Stanford University computer scientist Roy Amara postulated that we tend to overestimate new technology in the short run and underestimate it in the long run. In order to be truly “smart”, smart contracts would require a composite and integrated ecosystem where seamless interoperability between different technologies and platforms is assured. Considering that the critical factors i.e. technology and infrastructure, user acceptance and legal ecosystem, which underpin any innovation are falling into place, it is only a matter of time, before smart contract become as ubiquitous as making a credit card purchase.
Contributed by: Chetan Lunkar, Director – Forensic and Dispute Services
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