Blockchain is a notable emerging technology to watch in 2019.1 In this article, we will walk you through the basics of blockchain technology and smart contracts, explain why arbitration is beneficial in smart contract disputes, and explore the challenges that may arise in an arbitration procedure.
Blockchain Technology in a Nutshell
Blockchain is a distributed ledger technology, an open source-based innovation that intends to change the way how transactions are performed. It is a decentralized database system. Once a new block is entered into the system, all users add that block to their current blocks and thus a chain of blocks creates a database. Each block is chained to the previous block and is recorded across a peer-to-peer network by using a cryptographic trust and assurance mechanism. Currently, a well-known example of a public blockchain is Bitcoin in which everyone is free to create a wallet, become a miner, and perform transactions.2 However, Bitcoin is only the tip of the iceberg when it comes to blockchain technology.
One of the most promising features of blockchain technology is smart contracts.3 Smart contracts are a set of codes embedded in blockchain that enable parties to engage in transactions by performing specified actions subject to certain conditions. It can be described as pieces of code stored on a blockchain that read and write data in that blockchain's database, triggered by blockchain transactions. Smart contracts operate via distributed nodes (computers) that can be in different jurisdictions. Smart contracts are conditional in nature as they are executed only if the specified conditions are met. One of the most notable features of smart contracts is that they are self-enforcing by nature. Once a smart contract is concluded on a blockchain system via digital signatures, the smart contract executes itself independent of the parties when the conditions are met. For example, imagine a smart contract based on an insurance relationship that includes the provision "once the temperature decreases to 0° Celsius, a transfer of assets will take place from the insurance company's wallet to farmer X." In the event that the temperature falls to or below the pre-arranged 0° Celsius and this information is provided to the system by oracles (third parties providing information and data to the blockchain system), the smart contract automatically initiates the action "transfer assets from the insurance company."4
Currently, only digital assets that exist on blockchain may be transferred via smart contracts, but in the future the application of smart contracts may expand beyond cryptocurrency assets to other information that may be recorded on blockchain such as copy rights, vehicle licenses, and real estate deeds.5
Arbitrating Smart Contract Disputes
Arbitration, an alternative dispute resolution mechanism in which parties agree to resolve their disputes before an arbitral tribunal, may play a vital role in the resolution of disputes arising in connection with or out of transactions made via smart contracts.6 Disputes may arise: i) between the parties of a smart contract (e.g., due to the sale of defective goods), ii) due to technical difficulties in the smart contract application, or iii) due to the performance of oracles should oracles feed erroneous information to the system and cause unjust enrichment. In this article, we will focus on disputes between parties.
Arbitration has several advantages for settling disputes arising from smart contracts. First, since smart contracts and blockchain technology are a novel and complex area, special knowledge by the arbitral tribunal is crucial. State courts do not yet have the technological expertise to deal with such complex disputes. However, in an arbitration dispute, parties may choose specialized arbitrators allowing the needed expertise into the proceedings. Second, there may be difficulties when determining the competent state court or governing law due to the distributed ledger technology. As smart contracts operate via distributed nodes across the world, it is hard to determine the contract's place of performance which would effect the competent state court and governing law.7 However, with arbitration, parties can choose the law governing their dispute as well as determine arbitration as the exclusive jurisdiction mechanism for the disputes arising between them, thus alleviating the uncertainty over jurisdiction and governing law. Third, arbitration is likely to resolve disputes in a shorter time compared to state courts. In institutional arbitration, parties may also resort to expedited arbitration mechanisms which would save even more time.8 Finally, privacy and confidentiality is always one of arbitration's main advantages.
However, arbitration is not without its challenges in the area of smart contracts.9 Imagine that a dispute arises between two parties in a smart contract. The arbitral tribunal's first job would be to determine that the parties actually decided their dispute would be settled through arbitration. The law in several countries requires that a valid arbitration agreement be executed in written form, either directly in the contract or as a separate agreement. At the time this article was published, to the authors' knowledge, no arbitration proceedings have been initiated yet solving a dispute arising out of a smart contract; therefore we are yet to know whether an arbitration clause within a smart contract would suffice for an arbitral tribunal. To be on the safe side, the best option would be to conclude a written main contract including an arbitration clause or a written separate arbitration agreement.
Assuming there is a valid arbitration agreement between the parties, another problem might arise after an ad hoc or institutional arbitral tribunal renders its arbitral award. There may be an arbitral award that party (A) shall pay an amount to party (B). The question then would be how the award is to be executed by the parties. As explained above, smart contracts are a set of codes performing actions based on pre-defined conditions. In order for the arbitral award to transpire in the blockchain world, this arbitral award needs to be entered into the blockchain mechanism. It is argued that an arbitral tribunal may insert its award into the blockchain as an oracle and accordingly the smart contract would perform the action ordered by the tribunal.10 In other words, the smart contract would transfer the assets from party (A) to party (B) as per the award. Yet, this may require the tribunal to receive pre-determined access to the smart contract.
Even if a valid agreement exists and the arbitral award is successfully entered into the smart contract, there is always the possibility that party (A)'s assets are not adequate in the blockchain system. In this case, party (B) might also want to resort to party (A)'s assets in the non-blockchain world, i.e. through the state court where party (A)'s assets are. That's when the need for enforcement of an arbitral award would arise.
The recognition and enforcement of foreign arbitral awards is regulated mainly by the Convention on the Recognition and Enforcement of Foreign Arbitral Awards ("New York Convention") to which 160 states are contracting parties, including Turkey.11 Additionally, in Turkey, the International Private and Procedural Law No. 5718 regulates conduct between parties where the New York Convention does not apply. According to these sets of rules, a competent Turkish court must render an enforcement decision for a foreign arbitral award to be executed in Turkey and Turkish courts may only do this if the judgment meets certain criteria.12 One of such criteria is the existence of a valid arbitration agreement between the parties. Above, we briefly mentioned that a valid arbitration agreement must be in written form. As the evaluation of these elements is independent of the competency decision issued by the arbitral tribunal, concern may arise if the state court decides that the arbitration agreement in a smart contract is invalid even if the tribunal decided that there was sufficient basis for competency. Under Turkish law, an arbitration agreement may either be included in the main contract as an arbitration clause or be in the form of a separate agreement. Additionally, an arbitration agreement must be made in writing and must be a written document signed by the parties or in the form of a letter, telegram, telex, or fax exchanged between the parties or via an electronic medium reflecting the parties' agreement. Likewise, Article II/2 of the New York Convention states that "the term "agreement in writing" shall include an arbitral clause in a contract or an arbitration agreement, signed by the parties or contained in an exchange of letters or telegrams". At first glance, smart contracts seem to be unable to fulfill the criterion for a valid written agreement. While it may be argued that a smart contract is an electronic medium, there is always the possibility that courts will decide otherwise. In addition, the term "electronic medium" exists in domestic Turkish law, but not in the New York Convention. Neither Turkish courts nor other state courts party to the New York Convention have faced the question yet of whether smart contract fulfill the written requirement of an arbitration agreement and no easy solution can be found within the doctrine either. Therefore, we reiterate the importance of erring on the side of caution and drafting a separate written arbitration agreement ensure that there are no difficulties in the enforcement of arbitral awards.
As blockchain technology progresses, not only cryptocurrencies but any assets registered to blockchain technology will be able to be transferred via smart contracts. This will inevitably lead to the rise of disputes between parties of smart contracts. In this article, we briefly explained the benefits of arbitration as well as the challenges smart contract disputes may face and provided some temporary solutions to overcome such challenges. Our belief is that with this emerging technology, arbitration will be a more convenient dispute resolution mechanism than litigation. Nevertheless, arbitration is not yet ready for this upcoming technology, so problems may occur in the stages of competency, implementation, and enforcement of arbitral awards. To answer these problems, arbitral institutions and law-makers would need to take action.
2. Miners performs transaction verification functions for a fee in the form of newly created bitcoin units. For more information: Ahmet Usta, Serkan Doğantekin, Blockchain 101, p. 123.
3. Alexander Savelyev, Contract Law 2.0: Smart Contracts as the Beginning of the End of Classic Contract Law, p. 15.
4. ICC Dispute Resolution Bulletin, 2018 Issue 1, Robots Replacing Arbitrators- Smart Contract Arbitration, p. 25.
5. Balázs Bodó, Daniel Gervais, João Pedro Quintais, Blockchain and Smart Contracts: The Missing Link in Copyright Licensing?, International Journal of Law and Information Technology, Volume 26, Issue 4, Winter 2018, p. 312. Available at: https://doi.org/10.1093/ijlit/eay014
6. Similar opinion: Francisco Uríbarri Soares, New Technologies and Arbitration, Indian Journal of Arbitration Law, Volume 7, Issue 1, (2018). Available at: http://ijal.in/sites/default/files/IJAL_Volume_7_Issue_1_Francisco_Uribarri_Soares.pdf
7. Data, Blockchain and Smart Contracts, Regulatory Task Force Report Swiss LegalTech Association (SLTA), p. 56. Available at: https://www.swisslegaltech.ch/wp-content/uploads/2018/05/SLTA-Regulatory-Task-Force-Report-2.pdf
8. Please note that arbitration institutions (such as ICC, LCIA, SCC, ISTAC, etc.) have not yet prepared or published any rules regarding the settlement of blockchain and/or smart contract disputes.
9. One debate regarding smart contract disputes is whether or not existing dispute resolution methods are sufficient. According to one approach, smart contracts may be adjudicated by existing alternative dispute resolution procedures. According to a second approach, the existing legal system cannot address the legal challenges of blockchain and smart contract disputes and thus a special mechanism in the blockchain should be established. There are some startups specialized in blockchain dispute resolution mechanisms in which arbitration mechanism is embedded into smart contract systems and once arbitral awards are rendered in the blockchain, the smart contracts transfer the assets. While we focused on traditional arbitration in this article, for more information you may refer to: Darcy Allen, Aaron Lane, Marta Poblet, The Governance of Blockchain Dispute Resolution, p. 5-7. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3334674.
10. ICC Dispute Resolution Bulletin, 2018 Issue 1, Robots Replacing Arbitrators- Smart Contract Arbitration, p. 25; Allen/Lane/Poblet, p. 7.
12. These criteria are set out in Article V of the New York Convention and in Article 54 of the Turkish International Private and Procedural Law No. 5718
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.