Smart Contract

Introduction

“A contract is an agreement creating and defining obligation between two or more persons by which rights acquired by one or more to act or forbearance on the part of others”. [1]

Salmond

Contract is an agreement that governs the rights and duties of the parties to the contract. A contract plays an important role in day to day life of every person. A contract is legally enforceable as it has the requirements and approval of the law. An agreement deals in the exchange of goods and services for which the consideration is made. These contracts are governed by the Indian Contract Act which grants the contractual rights to the citizens of India. The Act provides with the rights and duties and also the parties of the contract to successfully conclude business from everyday life transactions to evidencing the businesses of multinational companies.

Contract

Contract act is one of the important legislation which has been drafted by the Britishers and the principles enacted therein are the codification of the general principles which are governing transnational relationship. The basic principle of Contract has been remained same everywhere in the world, only certain technicalities remain different. But before the act was enacted, the contractual relationship was governed by the personal laws of different religious communities. At that also Britishers had their own laws to govern but because of the presence of so many divergent laws, it created confusion in implementation of the contract and also in case of breach of contract. The contract law clearly brings light to the origin of economic processes even it also state the importance of contract in order to have business with other persons in everyday life.

Indian Contract Act

The Indian Contract Act, 1872 which was enacted on 25th April, 1872 and came force on the first day of September 1872, clearly states the way to enter into a contract, execute a contract and what are the effects of breach of a contract. [2]The contractual capacity is restricted in certain situations and the act clearly states who are entitled for the contract.  A contract is between two parties, where the process of proposal or offer by one party and acceptance by other party is essential element for its formation. An offer is called as a clear proposal to another party to enter into an agreement on certain terms, after that there is an acceptance of that offer is made by the other party in respect of the goods and service which will be provided. Consideration is called a vital part of the contract it refers to what parties will gain from the agreement of the contract.

It is one of the principal Act governing all the contractual relations not only in the business world but also from day to day life. So, the formation of contract includes negotiations where the parties apply their mind make offer and acceptance to create a contract.

Pollock once stated that “Every agreement and promise enforceable by law is a contract”. [3]

Smart Contracts

There are different types of contract which are based on Creation, Execution and Enforceability even for a Duration. As we known in modern era everyone is moving towards the new technology, even the laws are amended as per new changes. It has caused a shift in the way individuals and organizations and even new types of contracts were introduced such as E contracts. One of the new type of contract which were introduced in this modern era is “Smart Contract”.

These Smart contracts are basically computer protocols that execute pre-determined rules of code. It is a self-performing contract where the terms between a buyer and a seller are written directly into lines of code. These contracts are kind of a computer protocol which digitally perform its functions of enforcement of the performance of contract. They get executed in the way they were coded and they don’t require the involvement of the parties or something. A small drawback of such contract is that once they have been placed on a blockchain they cannot be modified, although the parties later can alter it. But the benefit of this contract is that they will be executed in the same way they were coded, without requiring the involvement of the parties or a judge, by significantly reducing the chances of non-performance of contract.

History of Smart Contract & Challenges

Smart contract are defined as agreements wherein execution is automated, usually by computers in simple terms contracts whose terms and conditions are converted into a software code. 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 that is the performance of the contract.

The term “Smart Contract” was first introduced by computer scientist and cryptographer in 1994 by Nick Szabo. According to him smart contracts are digital protocols for information transfer that use mathematical algorithms to automatically execute a transaction once the established conditions are met and that fully control the process.

He defined them as a

“set of promises, specified in digital form, including protocols within which the parties perform on these promises”. [4]

Nick Szabo

Although the well-known example of smart contract is vending machine which we discussed earlier. Using the vending machine as a forerunner, Szabo stated that the digital revolution would alter the process of contracting which means traditional contracts would cease to be used. He also stated that smart contracts would improve the execution of “four basic objectives of contract design”which are observability, verifiability, privity and enforceability. An improvement in the execution of these four objectives would be beneficial for world.

According to Szabo’s “New institutions, and new ways to formalize the relationships that make up these institutions, are now made possible by the digital revolution. I call these new contracts “smart,” because they are far more functional than their inanimate paper-based ancestors. No use of artificial intelligence is implied. A smart contract is a set of promises, specified in digital form, including protocols within which the parties perform on these promises”. [5]Szabo’s concept of fully automated contracts that would both change the contract across jurisdictions.

The origin of Smart contract can also be taken from Ricardian Contracts, a concept published in 1996 by Ian Grigg and Gray Howland as part of their work on the Ricardo payment system to transfer assets. Grigg stated “Ricardian Contracts as a bridge between text contracts and code that had the following: a single document that is

 a) a contract offered by an issuer to holders 

b) for a valuable right held by holders and managed by the issuer,

c) easily readable by people (like a contract on paper),

d) readable by programs (parsable like a database),

e) digitally signed,

f) carries the keys and server information, and

g) allied with a unique and secure identifier.”[6]

As we known smart contract interpret, verify and automatically execute any transaction in respect with the terms. Smart contracts state, the rules relating to an arrangement in the same way as normal written contracts but they also implement them automatically all the conditions and obligations regarding it. These contracts are implemented using the electronic platforms, which consists of two elements: currency and contracts. In these contracts the medium shifts from paper to an electronic platform. These types of contracts allow the safe transactions between the parties.

Challenges in other countries

Even these contracts are part of E- Contract still it is not being enforceable in many countries due to these challenges:

  1. Non-Technical parties cannot be able to draft such contract.
  2. Difficulty in finding the liability as these contracts are also made by third party in cases where the party is facing technical capability to create.
  3. Difficulty in finding the final agreement between the parties.
  4. No negotiation due to its automated nature.
  5. Risk regarding hacking or failures etc.

So, these challenges are mainly faced during the use of such type of contracts. The smart contract is a blockchain system computer code. The terms of the contract are written in the codes already and these contracts interpret and automatically verify transaction and executes them.

The key features of smart contracts are-

  1. Once the smart contract is released, no one including the owner can modify its terms.
  2. Physical documents are not required to initiate and complete the transaction.
  3. Although users can remain anonymous, the smart contract records the transaction details.
  4. Moderators can track market activity, but cannot regulate the transactions.
  5. Smart contract transactions are irreversible.

Functioning of Smart Contracts in India

Smart contracts provide a platform for contracting with parties who are unknown to each other and may also become liable to the risks. In India these types of smart contract can be enforceable but if any of the challenges which we discussed above or the terms are not maintained in respect of the party which are having contract, or the consequences of a failed transaction took place due to such type of contract, then the legal system has no regulation to regulate these smart contracts. Although the use of such types of contract in our country is allowed but it doesn’t provide any protection of the law to the parties involved in such contracts. Even the situation may arise when the court will also refuse these contracts which are of the consideration are not mutual, then the contract will not be valid

As there is no legal framework in respect to such types of contract so the parties don’t provide any protection in respect of breach or any failure although these contracts are quite included in E contracts. But in respect to Indian Courts these contracts cannot be enforce. The reason behind it is that the definition of smart contract keeps on change and it is still in developing phase and there is no actual definition which defines it. Even if it evolves in to contract still it will be cause difficulties in making more and more modifications with the time in it. Although E- Contracts are allowed but these types of contract still needs time to get established properly.

Problem often Faced

The problem which arises in such type of contract is that as if Section 35 of IT Act 2000 which states [7]regarding E-Signatures which can only be obtained from a government designated certifying authority. But in smart contract they generates the hash key that is to be used in identifying the parties not the signatures. Even if the signature which is produced through such smart contract it will not be admissible and also disallows such type of contracts under Indian Laws.

But this blockchain technology has been accepted by SBI by launching ‘Bank Chain’ for sharing of KYC data among banks using blockchain, and pharmaceutical sector using blockchain to maintain their records among other applications. These contracts have a huge potential in India, with regard to the payments related to household activities and their monitoring like supplies, e-commerce, where it works with algorithms. Although still there is no clearly in respect of how these contracts will be codified.

Conclusion

It is clear that the implementation of smart contracts is next step of innovation and it will likely to change many things, it is a revolutionary and will directly result in the reduction of overhead costs in billons while at same time making this all process easier and safer. Although there is no such regulations also in India regarding this and if no specific regulations are made then a wide range of amendments will be made in different enactments by the government of India. Although there is a small progress in these types of contracts and nowadays business sectors of India are also quite shifting towards its applicability, but sill it will take time.

Questions

Question 1: Is this contact covered under Indian Contract Act 1872?

Question2: What are the challenges faced by such type of contracts?

Question3: What type of mechanism used by Smart Contracts?

Question 4: What steps taken the Government in adopting such technology?

Question5: Does it has any regulations or specific act dealing with it?

References


[1] Sir John William Salmond

[2] Indian Contract Act 1872

[3] Sir Frederick Pollock

[4] Defination of Nick Szabo computer scientist and cryptographer

[5] Nick Szabo, ‘Smart Contracts: Building Blocks for Digital Markets’

[6] The Ricardian Contract by Ian Grigg

[7] Information Technology Act 200

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