In 1994, Nick Szabo, a legal scholar and cryptographer found that decentralized nature of cryptography could be used in smart contracts, which are basically self-executing contracts and ensure the performance of virtual agreements through blockchain technology to provide a hassle-free contract execution. The highlighting aspect of blockchain is its decentralized nature as it takes away the requirement of intermediaries (middlemen) and this, in turn, saves time and any conflict that may arise due to a third party.
A smart contract is a self-performing contract whereby the terms of the agreement that exist between a buyer and a seller are written directly into lines of code. A distributed, decentralized blockchain network contains the code, which consists of all the agreement terms. In addition to the agreements, the code also consists of information that executes the transactions and ensures that these transactions are tracked and are irreversible.
Thus, it can be said that a smart contract is mainly a kind of computer protocol to digitally perform the function of facilitation, verification as well as enforcement i.e, the performance of the contract. The key factors of a smart contract are as follows:
- Once the smart contract has been released, no one can change its terms, including the creator or owner;
- The execution and completion of the contract does not require and physical documents or submission;
- Although a user can be anonymous, the transaction details are recorded and registered;
- Transactions of smart contracts are irreversible.
How do Smart Contracts Work?
The code of the contract itself consists of the terms of the contract in concern. Smart contracts interpret, verify and automatically execute any transaction in tangent with the terms.
Let us take an example of a contract of rent made into a smart contract, to see the efficiency and effectivity of a smart contract. The tenant will pay the house owner the rent in cryptocurrency, as soon as the payment is made the code carries out the transactions in accordance with the terms of the contract as entered into the code. The homeowner will receive a receipt when the transaction is successful and will release the key to the house. The system operates on the If-Then principle, and hundreds of people involved in the blockchain will observe the transaction and become witness to the contract. If the home-owner gives the key, then he will surely be paid. If the tenant pays the amount, then he will surely receive the key. One action will not be completed without the other, hence providing an efficient and effective system.
Smart contracts not only specify the rules and penalties relating to an arrangement in the same way as a conventional contract but also implement those obligations automatically. These contracts are implemented using the “Ethereum” platforms, which consists of two elements: currency and contracts.
Smart contracts are essentially contracts in which the medium of interaction shifts from paper to an electronic platform. This raises the concern if these smart contracts can still be regulated by the existing legal framework or require a new legal system to govern such contracts.
The Benefit of Secured Transactions
Smart contracts allow a safe transaction to be enforced between the two parties concerned. The concept of a smart contract is that while one person shall gain something of value from the second party for collateral, the second party is ensured to be the only prioritized party to that collateral. It would be hard to implement this kind of functionality in the real world as various other factors would come into play, such as third or foreign parties entering into the contract.
“Ethereum” has made this possible because the ethereum network is transparent and the ability to determine and formulate who has priority over the collateral in question and can therefore easily accept or reject the collateral in question and can easily accept or reject the collateral and thus promote quicker and more efficient implementations of contracts.
Regulation of Smart Contracts Around the World
The elemental factors of a conventional contract must be met by smart contracts in order to qualify as a valid contract are: -
- A legitimate offer;
- A properly communicated acceptance;
- Lawful consideration pertaining to the subject matter;
- Consent of all competent parties in regards to all aspects of the contract.
The Uniform Electronic Transactions Act (UETA) was implemented in about 47 states in the United States in the year 1999. The UETA placed regulations on electronic contracts, records and signatures and stated that electronic contracts would be valid, and the use of electronic signatures was a valid way of providing contractual consent.In the European Union (EU), Rome I Regulation is the legislation which determines the legality of all EU civil and commercial contracts.
The United Kingdom is keen on integrating smart contracts into their legislation, the UK Law Commission which is an independent law commission formed by the Parliament under the Law Commissions Act of 1965 to review and propose changes in England and Wales Law, has begun a research project on reforms that would make the use of blockchain-based smart contracts legally clear.
The Law Commission claims that smart contracts have the benefit of increasing “confidence and certainty” and enhancing business-to-business transaction performance. As such, in order to make the current UK legal system adapt to emerging technology and boost business.
Statutory Overview of Contract Law in India
The Indian Contract Act of 1872, is the predominant statuary regulator of contracts. The act lays down the basic elements of which a contract comprises of in Section 10 that “all agreements are contracts if they hold the free consent of parties willing to contract, for a lawfully accepted consideration and with an object.”
Any agreement can become enforceable by law as a contract if it consists of an offer, acceptance and consideration. It would seem by definition, smart contracts are allowed under the Indian Contract Act 1872. A smart contract consists of the offer, the acceptance and consideration in the form of crypto-currency, this raises the issue of whether crypto-currency is acceptable as consideration under Indian law.
Section 5 and 10 of the Indian Information Technology Act 2000 legally accept digital signatures and find a contract to be legitimate and enforceable by electronic means. Furthermore, Section 65B of the Indian Evidence Act 1872 states that contracts digitally signed shall be admissible in the courts. The government is therefore enabled to take legal action to settle the conflicts between the parties.
Legal Functioning of Smart Contracts in India
Smart contracts basically provide a platform for contracting with parties who may or may not know each other and may also become liable to the risks. Smart contracts may be enforceable under Indian law, but if caution is not maintained in regards to the party that you are contracting with, the consequences of a failed transaction must be carried alone, as the legal system has no intricate system in place to regulate smart contracts.
Situations in which a smart contract may not be enforceable under Indian law could be if the consideration of the contract was not mutual. This can occur if the contract is unilateral in nature. The Indian courts do not allow contracts to be valid without mutual consideration, however, smart contracts without mutual consideration can still be enforced through code, but a breach of such a contract would not be held as a breach in Indian courts as, in the eyes of the court there wouldn’t be a contract in the first place due to a lack of mutual consideration, an important factor of a contract.
The legality of smart contracts in India allows for the use of smart contracts, however, it does not provide the protection of the law to the parties involved in the smart contract become liable or incur damages as there is no regulatory framework in place to govern the smart contracts, the law will help to the best of its extent if the smart contract falls within the boundaries of contract law as defined in statute.
Risks of Smart Contracts
Despite Indian law allowing electronic contracts, Ponzi schemes which are further facilitated with the help of blockchain technology questions the viability of safeguarding people’s interest.
Here arises the problem there are no well-established legal frameworks to regulate Crypto-transactions, be it in India or anywhere else in the world. According to Section 35 of the of the Information Act, an electronic signature can only be obtained from a government-designated certifying authority. This raises the concern, as for the contract to commence it is the blockchain technology that generates the hash key that is to be used as an identifier to authenticate the smart contract, there is no legal authority that sanctions electronic signatures.
Section 88A of the Indian Evidence Act states that the court presumes that an electronic record produced in court is genuine, but does not make any presumptions about the sender of the contract. Therefore, if a signature obtained through the blockchain technology is used, it will only make the admissibility of a smart contract more complicated as the signature was not obtained under the Information Act. This not only vitiates the system of encryption present in the blockchain technology for smart contracts but also disallows the submission of smart contracts as evidence before the tribunal.
Smart Contracts in Practice
Bajaj Electrics is a leading electrical equipment manufacturing company which is part of the Bajaj Group. It is easily one of the key players in the Indian Economy, the business activities of the company affect several sectors and vendors both inside and outside the company.
The payment process for vendors was long and cumbersome, this is so as there are various vendors that Bajaj deals with and they must ensure that the transaction between each vendor had taken place appropriately. The process of payment involves the vendor to show Bajaj Electricals’ verification of delivery, raising a supplier’s physical bill of exchange, and submitting an invoice and transport documents to Yes Bank as proof of delivery to receive payment.
This prompted the management of Bajaj Electricals to explore a fast and safe solution to replace its system of manual billing. Blockchain was the solution which they decided upon. In January, the company declared that it was going to use a solution developed by Yes Bank focused on blockchain vendor financing also known as supplier financing.
According to Chetan Bhanushali, Treasury General Manager, Bajaj Electricals Ltd, the use of blockchain removed the numerous steps involved in the bill discounting process of the business and the entire transaction became paperless. The new process has reduced the entire system cycle for the payment at Bajaj Electricals from five-four business days to almost real-time.
Yes Bank in India is not alone in pursuing and experimenting with supplier finance blockchain. For example, the Mahindra Group and IBM revealed in November 2016 that they are co-developing a cloud-based blockchain framework with the potential to reinvent supply chain finance in India.
Meanwhile, the Institute for Banking Technology Development and Research, an RBI agency, recently published a white paper on blockchain technology to allow banks and financial institutions in India to look forward to their own blockchain journey.
There is no question that the implementation and growth of smart contracts is the next step of innovation and can lead directly to billions of overhead costs being minimized while making the whole system more efficient.
Regulatory issues, however, exist, especially in India where there are no regulations regarding the finer details of a smart contract. If specific regulations are not made, a wide-ranging adoption of the technology will require the government to make amendments to the Indian Evidence At, 1872 and the IT Act.
Therefore, although there is certain progression of the legislation as well as business sector growing into the smart contract concept, the law is still functioning in a grey area, vigorous dedication is required to establish an intricate framework to regulate the functioning of smart contracts in India.
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