Getting Smart with Smart Contracts
The year 2020 has long been the target year for predictions. Our 2020 vision that once comprised of the widespread use of solar-powered flying cars, bell-boy bots, drone motorized deliveries and blockchain-powered bank accounts has dwindled down to finding a cure for the novel Corona Virus!
However, Covid-19 is only the most recent factor limiting (or proliferating, some may argue) technological progress, historically regulatory environments around the world have significantly curbed the ability of technology to deliver our 2020 vision. Among the most highly debated regulatory movements is the regulation of cryptocurrencies. Several countries including India, have imposed restrictions on trading and exchange of cryptocurrencies. Meanwhile, another fascinating application of blockchain technology (“BCT”) is gaining traction — Smart Contracts. `
Quick Recap: What is BCT?
Cryptocurrencies aren’t the only application of BCT. BCT is an internet protocol with abundant applications beyond just payments or money transfers, BCT can also be used in recording property titles, authenticating documents and creating smart contracts.
BCT can be broadly defined as a unique peer-to-peer network infrastructure that comprises of a distributed database of records and transactions (like a ledger) that keeps growing as more entries are added to it. The entire database is transparent, such that it is visible to all relevant stakeholders without the risk of any unauthorized alteration. The database is stored on multiple computers within the network, apprising each stakeholder of all changes to the database in real-time. This occurs as the device of each stakeholder is equipped with a unique code (“node”) which forms part of a network of nodes, updating the ledger as and when new transactions are authenticated. The process of authentication is based on advanced cryptography and is widely considered to be secure in and of itself and the data stored on such networks is immutable once recorded and accepted by all stakeholders, eliminating the reliance on a third party for transparency and authenticity.
BCT and Contracts
Section 2(e) of the Indian Contract Act, 1872 (“Contract Act”) defines the term Agreement as “every promise and every set of promises, forming the consideration for each other is an Agreement.” Section 10 of the Contract Act further states that all agreements that entered into by and between parties competent to contract (i.e. clear-headed individuals that are 18 years or older), with mutual consent, lawful objects and for lawful considerations are considered to be contracts under the Contract Act.
From a macroeconomic perspective, our economy can be reduced to complex large-scale human collaboration networks and the performance of respective underlying contracts. On a micro level, every individual ‘contracts’ with multiple parties on daily basis and in a variety of forms. Contracts could take the form of small purchases from a roadside vendor or a deal between two very large organizations. Immaterial of the size or nature, however, a common underlying feature of all contracts is that they require the parties involved to trust each other in order to make good on their promise or adhere to a system that enables this trust to be executed.
In practice misunderstandings and conflicts could potentially occur at each step — whether each party got what they bargained for and whether promises were kept with respect to the mode and manner of value exchange. These conflicts or disagreements can take a number of different forms and can cause delays or inefficiencies in the execution and performance of the contract, often leading to losses for the relevant stakeholders. Traditionally, such disputes are addressed by a network of intermediaries such as arbitrators, judiciaries, banks and even regulatory bodies that act as impartial and trusted agencies or facilitators for contract enforcement and ensure that all parties adhere to the commonly understood ‘rules of contracting’.
BCT represents another form of intermediaries — an eloquent code that encodes the so-called “rules” of contracting as a computer program, allowing different stakeholders with divergent interests to collaborate on an immutable ledger. BCT provides a transparent system that seamlessly adheres to the rules and fulfils the promise of not allowing transactions that did not comply to the agreed conditions. This aspect of BCT is invaluable — promoting the ease of performing and regulating contract performance via disintermediation and reduction of ad-hoc bureaucracy.
What are Smart Contracts?
Smart contracts are created by encoding logic statements onto BCT, working on the principle of If and then statements for example if the conditions prescribed are met, then the transaction will be initiated. Such contracts are executed based on rules that are pre-determined by all relevant stakeholders involved and are recorded and stored on BCT, equally accessible to all participating parties. The performance of each contract is enabled by technology that completes certain operations based on the rules defined by the participants. The smart contract is not reliant on a human third party or central operator.
Companies around the world have started experimenting with Smart Contracts and harnessing its capabilities. ICICI Bank Limited (“ICICI Bank”), Yes Bank Limited (“Yes Bank”) and Bajaj Electricals Limited (“Bajaj Electricals”) were among the first organizations to exploit smart contracts as early as 2016. Smart contracts were used to set protocols that facilitated, verified and enforced the negotiation of contracts. Yes Bank adopted smart contracts to help Bajaj Electricals digitize its process cycle for bill discounting, by reducing the time for processing disbursement of funds and discounting to vendors from 4 (four) days to almost real time. Meanwhile, ICICI Bank has been using this technology in partnership with Emirates NBD, a banking group in the Middle East, to facilitate instant cross-border remittances of funds in real time and showcase confirmation of receipt of imported materials.
Earlier this year, the National Payment Corporation of India (“NCPI”) launched its first blockchain-based payments platform called Vajra. Vajra operates by processing user requests through self-executing smart contracts that contain pre-determined rules set by NPCI. The on-chain data is then added to the ledger once the request is processed successfully and sent to the Reserve Bank of India (“RBI”) for settlement processing.
The customer initiates a transaction on the Vajra application through online banking, e-commerce, or point-of-sale and this request is then directed to the server of the payer, payee, or the issuing bank. The nodes or banks then receive and record the transactions on the platform using application programming interfaces or APIs, adapters or BCT. The smart contracts then validate and trigger transactions if the conditions set by NCPI are complied with. The transactions are then recorded on the distributed ledger technology and as a final step, NPCI clears files and fees from the blockchain platform and posts the same for settlement processing with the RBI.
The above used cases demonstrate how smart contracts have been adopted by various organizations to not only provide a greater level of transparency but also save time and resources, traditionally spent on paperwork, procedure, and intermediaries involved to support the execution and performance of contracts.
Legalese surrounding electronic contracts
Electronic contracts executed in India are primarily governed under the provisions of the Contract Act, the Information Technology Act, 2000 (“IT Act”), the Indian Evidence Act, 1872 (“Evidence Act”) and the Indian Stamp Act, 1899 (“Stamp Act”).
Section 5 read with Section 10(A) of Information Technology Act, 2000 (“IT Act”) provides that an electronic contract is deemed to have been validly executed if it is authenticated by a digital signature, in accordance with the procedure as set out under the IT Act. Section 35 of the IT Act further states that an electronic signature can only be obtained from a designated certifying authority of the Central Government of India.
Section 65B of the Evidence Act stipulates that any information contained in an electronic record that is printed on a paper, stored, recorded, or copied in optical or magnetic media produced by a computer, is considered to be a valid document if it satisfies certain conditions set out under the Evidence Act and is admissible before the court without further production of evidence of any contents of the original or of any fact stated therein. Section 85B of the Evidence Act further clarifies that where an electronic document is an agreement, it would be considered as a valid agreement only if authenticated using an electronic signature obtained in accordance with the provisions of the Evidence Act.
Furthermore, as per the provisions of the Stamp Act and state-specific stamp-related legislation, the payment of stamp duty is essential for treating an instrument admissible in evidence before a court of law. The definition of “instrument” under Section 2(14) of the Stamp Act means and includes every document by which any right or liability is, or purports to be, created, transferred, limited, extended, extinguished or recorded.
The admissibility of the electronic contracts (whether in the nature of smart contracts or clickwrap agreements) in courts in India is dependent on factors set out above and therefore disputes emerging among parties to electronic contracts can be settled in Indian courts only if the prescribed conditions are satisfied.
In light of the global pandemic, on 11 August 2020, the Ministry of Finance released a notification requiring all schedule commercial banks to integrate with the Digital Document Execution platform of the National E-Governance Services Limited (“NESL”) and to nominate a nodal officer to liaise with NESL and monitor the progress of such integration. The underlying idea behind this initiative was to devise solutions for enabling e-signing and e-stamping of documents, thereby enhancing ease, security and convenience to the public and avoiding the need for physical presence.
NESL was incorporated under the Insolvency Bankruptcy Code, 2016 as India’s first Information Utility to serve as a repository of legal evidence holding the information pertaining to any debt/claim, as submitted by the financial or operational creditor and verified and authenticated by the parties to the debt, it is also capable of facilitating digital execution of documents for financing transactions by way of the Digital Document Execution Platform. As an advanced paperless contracting solution, the Digital Document Execution Platform digitizes the end-to-end loan process and helps financial institutions to execute digital contracts within a short span of time and significantly lower administrative costs.
NESL allows three ways to affix/imprint electronic signatures: (a) Aadhaar-based OTP e-sign, (b) biometric based e-sign, and dongle based e-sign. The Aadhaar electronic signature service validates the authenticity of the person and provides for a public key infrastructure to sign documents digitally. Aadhaar e-Sign requires the signing party to either use their Aadhaar number to generate a time-bound one-time password (“OTP”) on their registered mobile number or use their biometric authentication via fingerprint or iris scan to affix their electronic signature on the document. e-Aadhaar signatures are recognised as an accepted method of secure electronic signatures under the IT Act. Alternatively, the signing party can also use their digital signature certificate stored on a USB dongle or any other secure storage device. The system is based on pairs of keys called public key and private key. Private keys are not shared, they are simply stored at the user’s end (e.g., in the USB dongle). The public key on the other hand is published to everyone, granting other users an easy and convenient method for verifying digital signatures.
Concerns relating to Smart Contracts
While smart contracts help stakeholders increase efficiencies and reduce costs significantly, there are certain challenges arising out the nature of these contracts that have limited the use of such electronic contracts. These challenges can be broadly categorized into two categories, namely:
(i) Lack of flexibility
Smart contracts are governed by pre-determined rules set out by all parties and are immutable thereafter. This makes the entire process rigid and leaves no scope alteration or modification in case of contingencies. Traditional contracts on the other hand can be altered and modified by either of the parties with the consent of the other contracting party.
Traditional contracts offer flexibility and leave room for negotiations among the parties executing the contract in case of any unexpected events. Contracting parties have the freedom to consensually alter commercial terms, offer waivers to certain conditions and even extend the closing / long-stop date once the contract has been executed. Smart contracts, however, do not provide the contracting parties with such liberties, which can in certain cases lead to frustration of the contracts.
(ii) Ambiguity in Enforcement
While smart contracts are recognized under Indian law, the Indian legislature lacks the necessary frameworks required to regulate such contracts, creating ambiguity in its enforcement.
For instance, a smart contract is executed by a single party using a hash key that is to be used as an identifier to authenticate on BCT and does not qualify as an electronic signature under the IT Act or the Evidence Act. According to Section 35 of the IT Act, an electronic signature can only be obtained from a government-designated certifying authority. This disallows the submission of smart contracts as evidence before the courts in India.
Further smart contracts provide a platform for contracting with parties who may or may not know each other and can be executed unilaterally, violating the necessary conditions under Section 10 of the Contract Act. Situations may arise wherein a smart contract stipulates certain terms and conditions that may not be mutual. While under Indian courts do not consider a contract without mutual consideration to be valid, smart contracts without mutual consideration can nevertheless be executed through code. A breach of such a contract, however, cannot be disputed in Indian courts as in the eyes of the court the contract is void ab-initio due to the lack of mutual consideration.
To conclude, 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 executing such smart contracts. At present the Indian legislative system does not completely support the execution of smart contracts. It is unclear and yet to be seen how disputes arising from the breach of smart contracts would be treated and settled by the courts in India, primarily due to the lack of comprehensive regulations governing such contracts. The Indian legislative framework surrounding smart contracts is at a nascent stage and in need of further development and until then it is advisable to exercise caution while executing BCT powered contracts.